China - Revenue mobilization and tax policy

L~X 6.050 A WORLD BANK COUNTRY STUDY S li China Revenue Mobilization and Tax Policy FILE COPY , t L~ U-~ .   A WORLD BANK COUNTRY STUDY China Revenue Mobilization and Tax Policy The World Bank Washington, D.C.  Copyright i 1990 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing June 1990 World Bank Country Studies are among tlhe many reports originaLLy prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are pubLished in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. 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ISSN: 0253-2123 Library of Congress Cataloging-in-Publication Data China : revenue mobilization and tax policy. p. cm. -- (The World Bank country study) ISBN 0-8213-1593-5 1. Taxation--China. 2. China--Appropriations and expenditures. 3. Revenue--China. 4. Intergovernmental fiscal relations--China. 5. Tax administration and procedure--China. I. Series. HJ2986.C47 1990 336.51--dc2O 90-38992 CIP  - iii - Foreword 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 from Anthony Pellechio (Direct Taxes) and Christopher Heady (Consultant, Indirect Taxes); Roy Bahl (Consultant) 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).  - iv - CURRENCY EQUIVALENTS The Chinese currency is called Renminbi (RMB). It is denominated in Yuan (Y). Each Yuan is 1 Yuan = 10 jiao = 100 fen Calendar 1988 Jtne 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 Bureau 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  - v - Table of Contents Page No. Summary and Conclusions .............................................. ix Preface .............................................................. xxiii 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 ............................................... 6 C. Revenue and Expenditure Issues: The Macroeconomic Perspective .............................................. 15 D. Conclusions ................................................ 20 II. REFORMING THE TAX STRUCTURE ................................... 22 A. Key Features of China's Present Tax System ................. 22 The Tax System in 1988 ................................... 22 The Taxation of Individual Incomes ....................... 28 The Structure of Domestic Indirect Taxation .............. 28 Other Indirect Taxation .................................. 31 Other Minor Taxes ........................................ 32 Implicit Indirect Taxes .................................. 32 B. The Impact of the Current Fiscal Regime .................... 33 Indirect Taxes ........................................... 33 Business Tax ............................................. 40 Enterprise Income Tax .................................... 40 Extrabudgetary Construction Tax and Wage Bonus Tax....... 43 Resource Tax .............................................. 44 Agriculture Tax .......................................... 44 Personal Income Adjustment Tax ........................... 45 Taxes on External Trade .................................. 45 Taxes and Industrial Policy .............................. 46 C. Recommendations ............................................ 47 Indirect Taxes ........................................... 47 Implications of Recommended VAT Changes .................. 51 Unifying the VAT Rate .................................... 54 Taxation of Enterprises .................................. 58 Resource Tax ............................................. 64 Other Taxes .............................................. 66 The Reform Package and its Revenue Implications .......... 67 The Phasing of Tax Reform: A Summary ..................... 68  - vi - Page No. III. CENTRAL-LOCAL FISCAL RELATIONS AND REVENUE SHARING ............ 72 A. Fiscal Decentralization and[ the Role of Local Government: Principles, Criteria and the International Practice .... 72 Fiscal Centralization vs Fiscal Decentralization ......... 72 What Revenue Raising Powers for Subnational Government? ............................. 73 Intergovernmental Transfers .............................. 74 China in an International Context ........................ 76 B. The Present System of Subnational Finance in China ......... 79 Provincial Government Finances ........................... 80 Budgeting and Financial Planning ......................... 83 Tax Administration ....................................... 84 Provincial and Local Revenues ............................ 85 Intergovernmental Fiscal Relations ....................... 87 Tax Sharing Between Provinces and Their Local Governments ...................................... 90 C. Initial Assessment and Issues .......................... .... 92 Other Problems and Issues ................................ 97 D. Options for Reform .......................................... 101 Limited Tax Sharing ......................... 102 Balanced Tax Sharing ......................... 103 Base-Sharing Model ........................................ 103 Patching Up the Present System ............................ 106 IV. TAX ADMINISTRATION AND COLLECTION .............................. 109 A. An International Perspectives on Principles of Administration 109 Efficiency in Administration .ill Machinery of Government .......................... 114 The Organization of the Tax Administration: Centralization vs Decentralization . 115 B. Tax Administration and Collection in China . 115 The Institutional Background . 115 Tax Collection Machinery and Practice in China . 120 C. Analysis and Issues . 121 How China's System Compares . 121 Machinery of Government . 122 Centralized vs Decentralized Administration . 122 Assessment . 124 D. Recommendiations and Reform Options for the Present System. 125 National Tax Service . 125 Near-Term Steps to Strengthen the SAT . 126 Organization and Strengthening of Provincial and Lower-Level Offices ........................ 130 Near-Term Administrative Reforms: Micro-Level Administrative Measures .131 Transition: Some General Considerations . 133  - vii - Page No. TABLES IN TEXT Table 1.1: China: Budgetary Revenues, 1980-1988 .................... 2 Table 1.2: International Comparisons of Expenditure and Taxation ... 6 Table 1.3: International Comparison of Revenue Structure ........... 6 Table 1.4 China: Developments in Government Revenue - Consolidated Government, 1978-89 ...................... 8 Table 1.5: China: Structure of Consolidated Government Expenditure, 1978-1989 ................................ 13 Table 1.6: China: The Budget and Its Financing .................... 14 Table 2.1: China: The Effects of Tax Cascading .................... 39 Table 2.2: Marginal Effective Tax Rates for Investment in Fixed Assets by Type of Enterprise in China ................. 43 Table 2.3: The Rate Structure of VAT in Selected Countries ......... 50 Table 2.4: Effects of Value Added Tax Change on Sectoral Profitability ......................................... 54 Table 2.5: Growth of VAT Revenue in Selected Countries ............. 58 Table 2.6: Eliminating Principal Deductibility: Revenue and Profitability Effects ................................. 63 Table 2.7: Summary of Recommendations .............................. 71 Table 3.1: Importance of Local Government Revenue Share: Selected Countries .................................... 78 Table 3.2: Tax Collection and Expenditure of Central and Local Governments, 1980-86 ........................ 79 Table 3.3: China: Revenue-Sharing System Between the Central and Provincial Governments, 1985-87 ....................... 89 Table 3.4: Changing Fiscal Importance of the Central and Subnational Government Sectors ........................ 92 Table 3.5: OLS Regression Results for Chinese Revenues and Expenditures Against Selected Independent Variables: By Province for 1985 .................................. 95 Table 3.6: Comparisons of Taxable Capacity and Tax Effort: By Province ........................................... 97 Table 4.1: Tax-Paying Entities by Type of Taxpayer - 1988 .117 BOXES Box 1.1: Recasting the Chinese Budget. 9 Box 1.2: The Contracting System .11 Box 2.1: Measures of Profitability, Reinvestment Rates and the Internal Growth Potential of Enterprises .36 Box 3.1: Formula Grants .77 Box 3.2: Revenue Allocation and Tax Sharing .86 Box 3.3: Revenue Sharing and Tax Effort .98 Box 3.4: Profit and Sales Tax Sharing Under a Base-Sharing Model. 105 Box 4.1: Audit Programs .......................................... 113 Box 4.2: Tasks and Responsibilities of the SAT ................... 117 Box 4.3: The Steps in Turnover Tax Administration ................ 123  - v.iii - Page No. FIGURES Figure 2.1: Allocation of Gross Incorne .............................. 24 Figure 2.2: Allocation of Net Income ............................... 26 Figure 3.1: Government Structure in China ........................... 81 Figure 4.1: The Hierarchy of Tax and Finance Bureaus ................ 118 Figure 4.2: Tentative Organization Chart of the SAT ................. 129 APPENDIX TABLES I. State Budget Revenue 1978-1989 .................................. 135 II. Functional Classification of State Budget Expenditure and Net Lending, 1978-89 .................... 136 III. Summary of the Tax System: State Budget, 1988 ................. 137 IV. Collection and Expenditure Disparities Among Provinces - 1985.. 147 V. Recent Increase in Revenues and Expenditures, by Province for 1983-86 .................. ................................ 148 VI. Changes in the Ratio of Expenditures to Collections, by Province for 1983-86 .................... 149 ANNEXES Annex 1: Reforming the Tax Structure in China ...................... 152 Annex 2: Subnational Government Finances in China .................. 223 Annex 3: Tax Administration in China ............................... 309  - ix - Summary and Conclusions i. In 1979 the Chinese government set in motion a process of reform aimed at decentralizing production and investment decisions and 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 greater 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 27% in 1985 was almost twice that of other countries at its income level. Even now, with a tax ratio just under 20%, 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 46%. 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 role. Moreover, China, like other socialist countries, levies almost no taxes on individual incomes. 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 allocation to improve, prices must adjust to reflect economic scarcities. At the same time, price reform cannot be separa- ted from tax reform, because changes in prices without changes in taxes would  - x - distort profitability. If price signals are to guide enterprise behavior, enterprises must also face a competit1ive environment. Specifically, enter- prises must face an environment in which they 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 taxes ithat 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 oE enterprise reform, while enterprise reform would strengthen the incentive efEects 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 price regimne'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 VAI' 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 VrAT structure similar to that of other countries. Such a VAT would have the advantage of minimizing distor- tions of the market prices, while fuliFilling the major tasks of revenue- raising, protecting the living standards of the poor and discouraging socially undesirable consumption. 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 implemented 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.  - xi - 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 following 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- tion 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 the 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 the 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 in 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 institutional characteristics that constrain tax reform: price controls and the absence 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 55X led to the bulk of tax revenue being collected from the three principal indirect taxes (product tax, VAT and business tax) and, to a significantly lower extent, from the enter- prise income tax. Both direct and indirect taxes continue to tap the 'surpluses' in the enterprise sector which have accrued following 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  - xii - affects sectoral profitability; product tax and VAT rates are theriefore fine- tuned in an attemfpt to ensure equalization of such profitability across sectors (although concern for industrial policy may permit some diEferences 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. Inasmuch 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, interpret:at:ion 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 re:inforce 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 package. They would restore to the tax system its primary role of raising revenue (and hence of aiding rnacroeconomic 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 bui;Ld 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 VIAT and the contracting and cither elements of the enterprise income tax) rather than recommending radlical change or a wholly new structure. The major recommendations and their justification are summarized below. xviii. Enterprise Taxation. With respect to enterprise taxation the report recommends: (a) that the present enterprise income tax continue to apply to the profits of all state enterprises at its current flat rate of 55X. Consideration should not be given to lowering the enterprise income tax rate, and to unifying the tax treatment of different enterprise  - xiii - types, until after reform of the contractual responsibility system and its tax preferences 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 for 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 55%, there are two reasons w'ny such a reduction 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 need 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 55% 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 through the taxation of state enterprises should receive higher priority than unifying tax treatment between different organi- zational units. Abolition 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 the tax base. 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.  - xiv - xxii. The rationale for the report's recommendation that the deductibility of amortization 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 supported 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 they are intended to discourage excessive investment and en,courage 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 regulate investment decisions. The adjustment 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 incorne tax continue to be applied to all resource using enterprises; (b) the resource tax be extended to al]. 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 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.  - xv - 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 social 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 inequality 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 income 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. 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  - xvi - 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 structure 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 standard rate of VAT of 15%, 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 supplementary 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 (b) 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 imply a lower tax burden). They can also enhance the equity of the tax system if higher rates are imposed on goods whose consumpt:ion is concentrated in better-off groups. The report's recommendation to maintain the present business tax has its roots in administrative considerations.  - xvii - Strengthening Subnational Government Finances xxxix. The overall reform process is changing the balance of revenues accruing to the central and local governments. 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. xl. The choice of a particular central-local fiscal relationship depends on how the government weighs the benefits of provincial responsibility for development versus less 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. xli. 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 amount 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? xlii. 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 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 goals; 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  - xviii - 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. xliii. A third model would be based on tax base sharing. This arrangement would have local and central governnnents 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 governmerLt 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 certral government tax. xliv. 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 goverrment 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 additiLonal taxes. Tax Policy and Macroeconomic Balance xlv. 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 prof'its and depreciation funds), without a corresponding degree of reduction 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 sustainable in the near term. However, a continuing downward trend in revenues without expenditure restraint would heighten concern about the fiscal deficit. xlvi. 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 government role or share in the economy, but rather a tool which effectively provides the necessary f'lexibility to meet changing expenditure and macroeconomic requirements as reforms proceed. xlvii. At the same time that a more effective fiscal policy instrument is needed, a number of developments over the reform period have reduced the  - xix - 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 varievy of reasons, mone- tary and interest rate policy have not been used as an effective tool for macroeconomic management. xlviii. 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 costs in mind.l/ If such precautions are not taken, it will be necessary to raise additional funds via the tax system. xlix. 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 contracting 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 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 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.  - xx - 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. Forrmal 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 t:he 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 alnd 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 cf 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 system which has been described as embodying the princi- ple of "unified leadership, multilev,el 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 problerns arising from the sheer size of the country. lv. But the system's inherent ambiguities also give rise tc, 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. 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 administration: (a) to introduce a "NatiorLal Tax Service" run by the central government, along the lines of e.g., the Inland Revenue, or IRS and with  - xxi - Central Tax Bureaus at the local level; and (b) to standardize and strengthen the present administrative structure 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 for Taxation and the introduction of an integrated management information system to assist management at all levels. Further steps would include: 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 system 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 resident 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.   - xxiii - 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.2/ 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 options 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 initia- ted 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 prov- inces. Tax reform continues to be an important factor in the success of China's reform effort. Hitherto, the steps for addressing the balance of revenue and expenditure and the fiscal balance between central and local gov- ernment 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 finance 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 responsibilities affect the role and size of the government budget. With greater autonomy given to enterprises and local governments, the central gov- ernment's effectiveness in mobilizing resources and its role in financing investment and other expenditures has diminished, 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  - 2 - 34% of GDP in 1978 to just under 20Z 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 genera- tion. Table 1.1: CHINA: BUDGETARY RIEVENUES, 1980-89 (%i of CDP) 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1988 1989 Budget Actual Budget I. Direct taxes /u 20.6 18.4 16.9 16.2 13.9 1.2.9 11.6 8.1 7.1 5.9 4.6 4.9 3.7 of which: remittances (19.1) (17.2) (15.9) (15.1) (12.9) (1.1.5) (9.9) (0.S) (0.4) (0.4) (0.3) (0.4) (0.3) II. Indirect taxes /b 11.9 11.4 10.8 10.9 11.1 1.0.2 10.1 11,6 11.2 10.0 9.3 9.5 9.5 III. Taxes on trade 0.8 0.7 0.8 1.1 0.9 0.9 1.5 2.4 1.6 1.3 1.1 1.1 1.2 IV. Other tax and nontax /c 1.1 1.2 1.0 0.9 1.3 3.4 3.2 4.5 5.3 5.4 4.6 5.2 5.8 V. Total Revenue 34.4 31.6 29.4 29.0 27.2 27.4 26.4 26.3 24.8 22.2 19.3 20.4 19.8 VI. Memo i tems: Total exp-nditures 34.1 36.7 32.8 30.3 28.6 29.1 27.9 27.1 27.1 24.8 22.0 23.2 22.1 Deficit 0.2 -5.2 -3.3 -1.2 -1.4 -1.7 -1.5 -0.9 -2.3 -2.6 -2.7 -2.8 -2.3 aJ Includes taxes on state enterprises, the adjustment tax, all profit remittances from state enterprises u:p to 1984, profits tax on collectivea (ICIT), and tax on extrabudgetary funds, construction tax, and other 'direct, taxes. , Product tax, VAT, business tax. /c Residual: includes depreciation funds and other taxes. Source: Ministry of Finance and IMF. 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 poli- cies; wage policy reduced surpluses in the urban household sector; and enter- prise surpluses were remitted to the budget. Indeed, until 1983, the bulk of government revenue, approximately 602, was generated from the remittance of profits (that is cost-price margins) by state-owned enterprises to the govern- ment budget. In the early 1980s, this system began to be replaced, on an experimental basis, with taxation of enterprise profits in an attempt to pro- vide state-owned enterprises with greater incentives for increasing effi- ciency. This experimental system featured, broadly, a statutory 552 enter- prise 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 away "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 relat:ion to input costs, in particular, raw materials ciDsts 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 sec- tor enterprises)l. Commodity taxes were also designed to equalize profits. In 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.  - 3 - 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 direct taxes than indirect taxes.2/ 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 rather than government grants as in the past (see Box 2.1 on "Alternative Measures of Profitability"). 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 introduction of a partial VAT to selected sectors of the economy; (c) var- ious low-yielding "pre-reform" taxes--salt tax, slaughter tax, market tax, agriculture tax, etc.--which accrued to local governments, were left in place; and (d) a series of ad hoc taxes on extrabudgetary "construction", wage bonuses, and extrabudgetary funds were introduced to control enterprise expen- ditures 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 1970s to the mid 1980s, it now applies to over 80Z 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 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, and the latter, falling, 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.  contract between government and enterprise determining profits or taxes to be remitted by the enterprise to the government.3/ The contract system has introduced a significant element of discretion into the tax system, with contracts negotiated on an enterprise-by-enterprise basis by the Finance Bureau of the government owning the enterprise. It has also led to certain comingling of the government's role as owner of enterprises seeking tax incentives for :investment and growth, and government's role as administrator of a transparent: and equitable tax system that establishes unifonn 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 beesn intro- duced, such as a "vehicle and ship usage tax", stamp tax, a banquoet 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 assignecl to local government in an attempt to increase their revenue sources. The housing and land taxes, although yielding little revenue now, 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 responsi- bility 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 33X of. total reve- nue); domestic indirect and commodity taxes (contributing 46Z); and customs duties (6Z). Agricultural sector taxation and personal income taxation together contributed an insignificant share (about 1.5%) of total revenue, while miscellaneous other low-yielding taxes contributed some 7X and nontax revenue contributed the remaining 6Z. Table 1.1 showed how these revenue trends have evolved over time, and reflects both the striking declining share of revenues in GNE as well as the shift in rteliance 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 3/ A full description of the Chinese tax system, up to 1986, is to be found in Finance and Investment, (CHA #6445) Annex III.  local governments have substantial effective control over the revenues they collect. From the perspective of tax collection, China is strikingly decen- tralized.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 gov- ernment 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 for- mula was to enable the provinces, in principle, to plan and budget over a multiyear period. 1.14 This initial reform program has undergone several changes since 1979. Under present arrangements, the central government has negotiated multiyear 'revenue" contracts" 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. Because 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 17% 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, 46X 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 6% of total revenues in China and almost 30% of total revenues in other low-income economies. 4/ Only in Brazil, Colombia and Nigeria, among developing countries, do subnational governments contribute significantly (25-35%). In most others, the subnational share of the total is in the 15-20% range, and in many it is 5% or less (See Chapter III for detailed table).  Table 1.2 INTERNATIONAL COMPARISONS OF EXPENDITURE AND TAXATION Country Group Per Capita Expenditure/ Revenue/ Deficit/ Income (S) GNP (X) GNP (X) GNP (%) 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 27.6 24.0 -5.8 Industrial countries 10,780 28.6 24.1 -5.1 Other socialist countries 2,000 86.0 62.0 -3.0 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 compara- ble. 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, UK, 1985. Table 1.3: INTERNATIONAL COMPARISON OF REVENUE STRUCTURE (% of Total Revenues) Income Other tax Country group and social Profits Commodity Tradeg 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 16.0 Low income countries n.a. 16.8 32.2 28.1 19.8 Middle income countries n.a. 25.7 25.6 8.3 22.6 Industrial countries 16 24.0 17.3 1.2 9.0 Other socialist countries 10 60-70 20-30 n.a. 1.0 Note: Central government revenues only for country groups; consolidated central aind local reve- nues for China on a GFS basis. Sources: World Development Report, 1988: Table 23, and P.T. Wanless; Taxation Centrallv Planned Economies; Croon Helm Publishers, Beckenham, IJK; 1985. Vito Tanzi; Quarititative Charac- teristics 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. 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 akin to personal. taxes. In most market countries, direct taxes are imposed on both personal and corporate incomes; on average, about 40X of direct tax reve- nues derive from the former and 602 from the latter. In China, the entire explicit burden of direct taxation is on the enterprise. B. RLevenue 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 8.3Z 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 those 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 2Z annually over the 10 year period, and declined from about 20X of GNP (60Z of total revenues in 1978 when all enterprise prof- its were still remitted to the budget) to an estimated 6.5Z of GDP in 1988 (32Z of budgetted revenue). Enterprise income taxation with its emphasis on 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.  - 8-. contracting has reduced the importance of profit remittances and taxes as sources of government revenue (see Box 1.2 on "mthe Tax Contracting; System"m). Less than 1.6% of total revenue now derives f'rom profit remittances, compared to 56Z in 1978. ra b Isa 1. 4: CHINA: DEVEILOPMENTS IN 4IOVSRNMENT REVENUE - CONSOLIDATED OOVERNHENT 19?78-89 /a (In I of GNP) Nominal Buoy- 1Q78 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1.988 1989 growth ancy / Budget ActualI Budget 1978-89 1978-89 Total revenue 34.4 31.8 29.4 29.0 27.2 27.4 :26.4 26.3 24.8 22.2 19.31i 20.4 19.8 -5.41 -0.33 Dr;ct Ta.asLJ 20.6 18.4 16.9 16.2 13.9 12.9 11.6 8.1 7.1 5.9 4.6 4.9 3.7 -15.91 -1.14 Profit tax (1.6) (1. -1) (:1.0) ((0.9) (0.9) (1.0) (1.3) (7.6) (6.7) (5.0) (3.9) (4.5) (3.4) (8.51) (1.31) Profit Remittance (19.1) (17.2') (1s.9) (11 (1.) (11.5) (9.9) (0.0) (0.0) (0.0) (0.0) (1)0) (0.0) (-10.41) (-1.04) Indirect Taxes 11.9 11.4 10.8 10.9 11.1 10.2 10.1 11.2 10.8 9.6 9.0 9.2 9.2 -2.61 -0.14 Product tnx (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (6.9) (5.6) (4.7) (4.0) p.) (3.3) (-16.61) (-1.25) VAT (0.0) (~~~~~0.0~ 00 00 (0.0) (1:.7~ (2.4) (2.2) (24 (28) (2.7) (11.71) (0.66) Busnes on (00) (00~ 0.) 0.) 0.) 0.0.0.0 (.5 2.) 27) 26 12.) (3.1) (5.61 (0.32) AIiulua tan (0.3) (0.3) 0.2~ (0.2) (0 .2~ '02) (0.1) (0.1) (0.1) (0.0) (0.1) o.1 (0.1) (-16.41) (-1.24) Tones in t. trade 0.8 0.7 0.8 1.1 0.9 0.9 1.5 2.4 1.6 1.3 1.1 1.1 1.2 4.21 0.44 Other taxes lb 0.3 0.3 0.2 0.2 0.5 2.4 2.0 3.4 3.3 3.2 2.9 3.1 3.3 26.61 2.15 Nontax r"emeueLe 0.8 0.9 0.8 0.7 0.8 1.0 1.1 1.1 2.0 2.2 1.7 :2.1 2.5 12.91 0.89 Menmo i tems: Extrabud. roceipt.: -of go.ernn,ent 0.0 0.0 0.0 0.0 0.0 1.6 1.8 1.7 1.6 1.5 1.3 1.3 1.3 -3.31 -0.26 -of public agon- ies /c 0.0 0.0 0.0 0.0 0.0 0.0 0.1 0.31 0.2 0.3 0.2 0.2 0.2 2.11 1.15 Profit revittsnces (19.1) (17.2) (15.9) (15.1) (12.9) (11.5) (9.9) (0.5) (0.4) (0.4) (0.3) (0.4) (0.3) -35.11 -3.55 GNP in current prices (Y bin) 356.8 399.8 447.0 477.3 519.3 580.9 696.2 656.6 972.6 1,135.1 1,385.3 1,385.3 1,567.7 la Consolidated central, provincial and local governments. Data on dlisaggregatedl basis for 1988 actual revenues was not *vai labia. 1988 total revenue (actuals) .as Y 281.4 billion, or 19.51 of ONP. Include:s:trees on%etrabuydgetary receipts, on entrabudgetary construction, and wage bonus ta.. Exclude etrpris retained earnings and depreciation funds. Includes profit remittances 1978-84. Includes profit remittances 19685-88.8 Buoyancy calculated as the logI linear form of: T =cay B e. All coefficients signiflca.t at 951 or above. Note: Alternative specifications of some of the buoyancy coefficients ware tested: (1) Sales tax as function of retail sales = (0.8). (i) Indirect taxes as function retails sales = (0.8). (Iii Trade taxes as a f'unction of (xms) = (1.1). (iv Agriculture tao as, a function of OVAO = (0.4). (v) Enterprise profits, as a function of OVID: (0.6) and not significant. Source: Milinit,y of Finance. (Note: Adjusted acco rding to CFS formalt, which differs from Chinesa budget). 1.20 Receipts from the personal income tax ar-e negligible because the vast majority of individuals are exempted, since their income is below the relatively high minimum taxable level of Y 400 per month. 1.21 Since ithea mid-1980s, indirect taxes have been by far the most impor- tant revenue source, accounting for a-bout half of total government revenue. However, while revenue growth from indirect taxes has been 12Z ovier the ten year period, revenaue as a percentage of GNP has decreased from just over l1% in 1978 to 9.OZ buidgetted in 1988. T'he policy of phasing out the product tax and replacing ilt with VAT is reflected in the respective growth rates of prod- uct tax (-2.7Z) an-d VAT (31.7Z). Revenue from the agricultural tax is low and has grown slowly, at about 5Z p.a., and has declined as a percentage of GNP since the late 1L970s. Behind this lies a political decision to maintain a minimal tax burdien on agriculture with low tax rates intended to stimulate agricultural outpuat. Poor tax administration has also played a part.7/ 7/ The agriculture tax is classified as an indirect tax as it is levied on gross output.  - 9 - Box 1.1: RECASTING THE CHINESE BUDGET The Chinese State Budget consolidates the budgets of the central and local govern- ments. 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 enterprises, as well as the so-called extrabudgetary funds. The presentation of budgetary accounts in China differs from that found in most other countries.1/ Among the major differences are that: (i) revenue in the Chinese defini- tion includes aIT proceeds from domestic borrowing (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 borrowings 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 enterprises 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 3% 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 summary 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 2.7% of GNP than 0.7% 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 industrial enterprises) as expenditure. Since in the Chinese definition of revenues, such subsidies have been netted out from gross profit remittances, to include them expli- citly 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. (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 extrabudgetsry transactions. While 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 3% of consolidated 'unadjusted' budgetary expenditure. Therefore, budgetary expenditure accounts (and financing items) have been adjusted by an estimated Y 8 billion in 1988 of known extrabudgetary expenditure. The finan- cing 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." 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 impor- tant point in assessing 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 5-6% of GNP.2/ 1/ IMF, A Manual on Government Finance Statistics, (Washington, D.C., June 1974). 2/ See Bosworth, Barry, 'Notes on Visit to Beijing", October, 1988.  - 10 - Box 1.1: (cont'd) 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 2863.5 Less: - foreign loan repayments 4.6 - 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 - "past surpluses" /a __ Equals: Total expenditure: recast format 3015.0 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 La - receipts from sale of st,ate assets /a -- Plus - loan repayments (foreign) 4.5 - loan repayments (domestic) - loan repayments (treasury bond) :2.7 Adjusteld overall deficit (-): recast format -3D0.1 /a No data available. 1.22 Trade taxes on imports and exports have exhibited the highest growth, at over 142 p.a. However, despite the rapid expansion of foreign t:rade 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 composit:ion 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 6-8Z of total revenue.  - 11 - Box 1.2: THE CONTRACTING SYSTEM The objective of the contract system has been to improve enterprise performance by strengthening financial responsibility, emphasizing profitability, and giving enterprises greater autonomy in decision-making. Though the specific nature of each contract differs in its detail, the system essentially revolves around an agreement between the management of the enterprise and its owner, that is, the central or local government or industrial bureau. The management contract covers a period ranging from 1 to 5 years and typically stipulates a mini- mum amount of profit to be realized and/or taxes to be paid each year to the Government. Indirect taxes, including customs duties, may or may not be included in the contract. Firms that fail to meet their minimum profit or tax objective may be forced to pay their tax obliga- tion from "self-owned fundsw, that is, their past retained earnings. Four major types of contracts are in common use, designed in accordance with the size of the enterprise and its economic form: (a) An 'Enterprise Management Responsibility System' (EMRS) applies to medium- and large-scale state enterprises and calls for the enterprise manager to meet an agreed profit target for a specified number of years. The first year profit target is set at the same level of profits earned in the year prior to the implementation of the system, ensuring that the Government's tax revenues (56% of the agreed target profit) do not fall short of the level attained before the system was instituted. For subsequent years, the profit target may be raised incrementally, and any above-target profits earned are taxed at a lower, sometimes as low as 3% tax rate. Indirect taxes are sometimes included in the contract, with sales over a particular level exempted. (b) A 'Contract Management Responsibility System' (CMRS) is in use for about 60-70% of all medium- and large-scale enterprises, but is slightly different from the EMRS in that it operates on the principle of target tax remittance rather than target profits. In one vari- ant, the enterprise manager contracts to remit a certain tax quota to the government supervis- ory unit which is increased annually, usually by 7%. No additional taxes are levied and above-quota profits are allowed to accrue in full to the enterprise. In another variant, the enterprise hands over a fixed direct and indirect tax quota each year, with the above quota profits accruing to the enterprise. (c) The 'Asset Management Responsibility System' (AMRS) variant of the contracting system puts the management of the enterprise up for bid, with managers indicating their esti- mate of the profits which they can achieve over the duration of the contract. Taxes under this variant are usually levied on the actual level of income earned in the period, with no remission of indirect or other taxes. This procedure can be used to value the enterprise: by taking the discounted value of the bid earnings stream (using as the discount rate, the inter- est rate on bank deposits) a value of enterprise net worth can be assessed. (d) 'The Leasing Arrangement System' applies mostly to small enterprises in the services sector. The enterprise manager commits to pay an agreed leasing fee, which usually comes out of after tax profits and the lease is secured by a mortgage on some personal assets of the lessee. In general, the lessee and employees are entitled to determine the disposition of the full residual income left over after payment of the appropriate level of taxes and the leasing fee. From the point of view of taxation, generally, leasing and the AMRS do not allow remission of taxes, while the CMRS tends to undermine the tax system. The EMRS occupies an intermediate position. An illustration of a typical EMRS contract's effect on an enterprise's and its decreasing tax rate is given by the Beijing 8roadcast Equipment Industrial Corporation. The enterprise's 1988 profits were Y 10.8 billion and its contract stipulates a minimum of Y 10.6 billion in profits after 1988 to be taxed at 66%. This guarantees an income tax revenue to the government of Y 6.8 billion. Any excess of profit over Y 10.6 billion will be taxed at the rate of 27.6%, thereby reducing the marginal tax rate by half. Assuming profit growth of 20% p.a., the effective average tax rate is 46% in 1987, 39% in 1988, 32% in 1989, and 28% in 1990. TAX CONTRACTS: EFFECTIVE TAX RATES Tax on Effective Above quota above quota Total average Year Profits Base tax profits profits tax tax rate (%) Y Y Y Y Y %I 1988 10.8 5.8 - - 6.8 55.0 1987 12.7 5.8 2.1 0.08 5.88 46.1 1988 15.2 5.8 4.6 0.14 5.94 39.0 1989 18.3 5.8 7.7 0.23 6.03 32.9 1990 21.9 5.8 11.4 0.34 6.14 28.0  - 12 - 1.23 In addition to tax and nontax budgetary revenues, the government receives so-called "extrabudgetary 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 hous- ing 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 0.9Z of GNP in 1982 to 0.3Z in 1987. Government agencies also collect revenues not reflected in the budget. Their "extrabudgetary revenues" account for about 3.5Z 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% p.a. 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 1.5 outlines these trends. A major factor in the decline has been the declining defense expenditures to GDP ratio, which fell from 4.6Z in 1978 to 1.7Z in 1988. Nondefense expenditures have grown more rapidly than totaLl expenditures and have therefore not fallen as rapidly as a share of GDP as total expendi- tures, declining from 29.2Z of GDP in 1978 to 20.3% of GDP in 1SI88. Within total expenditures, current expenditures grew far more rapidly, almost 13% p.a., than capital expenditures, wh:Lch grew only 3.9Z p.a. As a result, cur- rent expenditures as a share of total budget expenditures increased from 57Z of total expenditures in 1978 to an estimated 74Z of expenditures in the 1988 Budget. 1.25 The increase in current expenditures was mainly caused by subsidies which grew at more than twice the rate of total expenditures. Subsidies have increased from 9X of total expenditures in 1978 to 25% in 1988, and from 16% to 34Z of current expenditure over the same period. To some extent, this increase can be linked to the reforrm process, and pressures to protect urban consumers from price shifts in the absence of wage reform. Of the three major subsidy categories, subsidies to cover losses oE state-owned enterprises have increased most sharply, in particular since! 1985, owing to losses of an increasing number of state-owned enterprises. Subsidies for daily living necessities have also risen sharply, especially since 1987, when the Govern- ment began to compensate urban consumers for increases in official procurement prices. "Culture, education and health" expenditures growing at 15Z are also contributing to increased current expenditures. Major factors behind the latter increase are expanded college enrollment, vocational training, and the introduction of 9-year compulsory eclucation. Since the beginning of the reform process, the shares of defense and economic services expenditures have decreased, from a peak of about 14% of total expenditures in 1978 in each 8/ There are three types of extrabudgetary, revenues: retained earnings and depreciation funds of enterprises (Y 162 billion in 1987); revenues of governmient agencies (Y 35 billion); and extrabudgetary revenues of the government (Y 4.5 billion). Only the latter two of these is referred to in the this para. About 80% of extrabudgetary revenues are accounted for by the first type, and 17% and 3% respectively by each of the latter.  - 13 - case, to 7% and 9% respectively in the 1988 Budget. Reduced spending on eco- nomic services was mainly a consequence of the reduced role of government in providing working capital to state enterprises, now increasingly provided through the banking system. Table 1.5: CHINA: STRUCTURE OF CONSOLIDATED COVERNMENT EXPENDITURE, 1978-89 /a (in % of total expenditure) Nominal 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1988 1989 X growth Budget Actual Budget 1978-88 Total expenditure (1 of CNP) 33.8 37.3 33.7 31.2 29.4 30.0 28.7 28.0 27.9 25.8 21.1 22.9 20.8 -4.7% Nondefense expendi tures (X of ONP) 29.2 31.6 29.2 27.6 25.9 26.9 26 25.7 26 23.9 19.4 21.3 19.3 -4.1% Capital expenditures (% of GNP) 14.7 15.4 10.9 8.0 7.9 7.6 8.2 7.7 8.0 7.0 5.4 5.8 4.7 -10.8% Current Exxenditure 56.5 58.7 67.7 74.2 76.3 74.8 71.2 72.3 71.3 73.3 74.4 74.6 77.2 3.2% % of total Administrative 4.0 3.9 4.6 4.9 5.5 6.0 7.1 6.2 6.4 6.4 5.9 6.8 6.6 5.11 Defense 13.7 15.2 13.3 11.6 11.9 10.5 9.3 8.3 7.7 7.5 7 6.7 7.1 -6.3% Culture, education, health 9.2 9.0 10.7 11.8 13.3 13.2 13.6 13.5 14.5 14.4 14.7 15.1 14.9 5.0X Economic services 14.6 12.7 13.1 11.6 11.9 11.1 10.5 9.6 9.5 9.1 9.1 9.0 9.0 -4.71 Subsidies: 9.3 13.3 18.7 25.5 25.1 25.2 21.1 21.8 21.5 23.7 25 23.7 26.8 11.21 Daily necessities (6.4) (10.9) (16.4) (21.1) (20.2) (18.3) (16.2) (13.5) (9.2) (10.4) (11.7) (9.8) (11.8) (6.3%) Agricultural inputs /b ().) ( ) (. ) (1.5) (1.4) (0.8) (0.5) (0.6) (..) (..) (C.) (C.) < ) (-20.5%) Enterprise losses (2.9) (2.4) (2.3) (2.9) (3.5) (6.1) (4.4) (7.7) (12.3) (13.3) (13.3) (13.9) (15.0) (17.91) Other 5.6 4.6 7.3 8.7 8.6 8.9 9.6 12.8 11.7 12.1 12.5 12.1 11.5 7.5% Caaital exeenditur. /c 43.5 41 3 32 3 25.8 23.7 25.2 28.8 27.7 28.7 26.7 25.6 25.4 22.8 -6.31 Memo Item: Total Exp. (Y) 122.5 146.9 146.4 144.4 148.3 169.0 193.9 232.4 262.2 281.5 305.0 321.3 346.2 10.9% /a Totals may not add up to sum of components because of rounding. Data on a disaggregated basis for actual 1988 expenditures were not avail- able. Total expenditures in 1988 were Y 315.6 billion, or 22% of CDP. b Not listed separately in 1978-80; since 1988 included in subsidies for enterprise losses. t Includes 7 billion of extrabudgetary capital construction (1987) and Y 8a bilion in 1988. No figures available in earlier years. Source: Ministry of Finance. (Adjusted to OFS format.) 1.26 Capital expenditures have grown at only 3.9Z, and the share of capi- tal expenditures in the budget therefore fell sharply, from 44% in 1978 to an estimated 26Z in the 1988 budget. In terms of GNP, capital expenditures have fallen from 14.7% in 1978 to 5.6% in 1988. This decline occurred mainly as a result of reduced budgetary financing of state enterprises' capital investment (and consequent increased reliance by enterprises on their own retained earn- ings and domestic and foreign bank loans). At this stage in the reforms, budget sources finance less than 37% of total state sector fixed investment, compared to 79Z in 1978. This decline in budget-financed capital expenditures goes along with profit retention permitting enterprises to keep a larger share of their earnings. 1.27 Developments in the Budget Deficit. In the initial years of the reforms, the budget was characterized by large deficits, as a result of the combination of enterprise profit retention, large consumer subsidies, and ambitious investment plans. A reduction of capital outlays relative to GNP and a decline in subsidies for daily necessities then narrowed the deficit. But since 1985 the deficit has been rising and is expected to be 2.2% of GNP in the 1988 budget (See Table 1.6). On the revenue side there is the slow growth of tax revenues whose causes were discussed previously. On the expen- diture side, the main reasons are the growth in subsidies to loss-making enterprises and difficulties curtailing nondefense expenditures, especially capital outlays, due to pressing needs for investment in basic infrastructure, energy, and transport development.  - 14 - Table 1.6: CHINA: THE BUDGEr AND ITS FINANCING 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1988 1989 1989 Budget. Actual Budget Est. (In bi lions of nuan) Revenue 123.3 126.3 131.6 138.6 141.2 159.4 183.5 228.3 244.3 255.7 274.7 286.3 315.8 320.0 Expenditure 122.5 146.9 146.2 144.4 148.3 169.0 193.9 232.4 262.2 281.4 305 321.3 346.2 353.0 Deficit 0.8 -20.6 -14.6 -5.8 -7.1 -9.6 -10.4 -4.1 -17.9 -25.7 -30.3 -35.0 -30.4 -33.0 as % of ONP ( X) 0.2 -5.2 -3.3 -1.2 -1.4 -1.7 -1.5 -0.5 -1.8 -2.3 -2.2 -2.5 -1.9 -2.1 (As % of total deficit) /a Financing: 100.0 100.0 100.0 100.0 100.0 100.1 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Domestic: 125.0 82.5 84.9 44.8 102.8 88.6 82.9 97.6 71.7 72.4 72.9 67.1 60.5 63.6 PBC (125.0) (82.5) (84.9) (-39.7) (40.8) (44.8) (42.9) (-51.2) (38.0) (26.0) (.. (22.6) (C.) (15.2) Bank/Nonbank (..) (..) (C.) (84.5) (62.0) (43.8) (40.0) (148.8) (33.7) (46.3) (72.9) (44.6) (50.5) (48.5) Foreign -25.0 17.5 15.1 55.2 -2.8 11.5 17.1 2.4 28.3 27.6 27.1 32.9 39.5 36.4 /a Total& may not add up tCo sum of components because of rounding. Source; Ministry of Finunce. (Note: All figures adjusted to GFS basis:). 1.28 The deficit was mainly financed domestically in the early years of reform, by the People's Bank of China (PBC) and increasingly since 1981 by domestic bank and nonbank borrowing through bond allocations to banks, enter- prises and households. Since 1986, foreign borrowing has been an increasing source of finance. 1.29 Although the economy experienced macroeconomic (especially external) imbalances at various times in the post-reform period, it is diff.icult to trace the cause of these disturbances to the budget deficit. In many coun- tries, uncoordinaLted tax and expenditure poLicy, and the excess cdemand genera- ted by the resulting budget imbalance lead to both price pressures and a bal- ance of payments deterioration, with the relative extent of price and external pressures depending among other things, on the relative importance of tradable and nontradable goods and the manner in which the deficit is financed. The more open the economy--and China's economy until recently was relatively closed--the more likely the external spillover. China's heavy reliance on tariffs and import controls helped contain such pressures and enabled a fixed exchange rate policy to be maintained without pressures on foreign reserves. 1.30 With respect to domestic priessures, the excess demand created by the deficit was not reflected in rising prices, because of the public's apparent willingness to hold money and maintain high savings.9/ Because of the deficit's relatively small size in relation to GDP, the relatively low abso- lute level of debt, as well as the rapid growth of GNP, domestic financing pressures have been largely absent. With the issuance of Treasury bills in 1981, China, like other countries, had three choices in financing the deficit: borrowing from the public; borrowing from the banking system; and borrowing from the central bank. The financing of the deficit by domestic borrowing from the public and the banking system in most countries would have affected interest rates and investment, increased intermediation spreads and distorted the allocation of credit in the economy. In China, domestic financing was not allowed to push up interest rates which were maintained at low, administered levels, while domestic investment was able to expand thanks to accomodative monetary policy, and was allocated according to plan. Government borrowing 9/ The Country Economic Memorandum (CHA-7483) discusses the dyna,mics behind these shifts in savings in Chapter IV: "Investment Behavior and Domestic Resource Availability".  - 15 - from PBC to finance the deficit was not, up to 1986, a major contributor to monetary expansion. 1.31 In 1987 the financing situation changed, with PBC financing 37Z of the deficit and accounting for about 40Z of reserve money growth. In 1988 PBC was budgeted to finance 26Z of a similar sized deficit; however, there was reportedly no PBC financing of overdrafts in the first half of the year, a policy which the government intends to maintain throughout the year, financing the deficit with bonds allocated to the banking system. However, the implica- tions for monetary growth may not be much different than direct PBC financing, especially if specialized banks obtain additional PBC credit to finance their mandatory bond holdings. 1.32 All told, it appears that a deficit on the order of between 2-3Z of GNP is modest, especially in view of the fact that this is not a deficit on current account. The problem, if there is one, is not so much with the pres- ent size of the deficit, as with the trend. If tax buoyancy is not restored, the Government's development initiative that comes from command over a large pool of fiscal resources may be impaired, while a widening of the deficit will also impair stabilization efforts. C. Revenue and Expenditure Issues: the Macroeconomic Perspective 1.33 In China and other socialist economies, unlike in market economies, the stabilization aspect of tax policy has not been a major concern. This has been because the major sources of macroeconomic instability--unforeseen changes in investment, consumption and savings--were thought to be controlled in large measure by planners. However, as decision-making is decentralized and as submerged disequilibria emerge in the course of reforms, the socialist economy will also need to address macro imbalances. In the post-reform Chinese economy therefore, consideration needs to be given to the stabiliza- tion aspects of fiscal policy. In the short run, tax policy may not have a significant role to play in demand management. In the longer run, however, the central government needs stronger tax levers to supplement its reliance on administrative cutbacks in state investment expenditure as the primary fiscal tool. A stronger fiscal tool should not be construed as calling for a larger government role nor a higher level of taxes. Rather it suggests a set of revenue instruments sufficient for the government's revenue needs (these are likely to change in the course of reforms), which promotes its objectives of economic stability and growth. 1.34 From a macroeconomic point of view, and at a time when expenditure trends are difficult to predict, the reduced flexibility over tax policy emerging as a result of contracting and the decentralization of fiscal arrangements represent potentially worrisome developments. At the same time, the growth in extrabudgetary funds has made it difficult to ascertain the effective fiscal stance of the government and concern over inflation has led to hesitancy over further price (and tax) reforms. In this section, these issues are in turn discussed. 1.35 Contracting. The contract system was designed to stimulate enter- prise production and investment. It will in the longer run result in an expansion of the tax base to the extent it is successful in promoting the  - 16 - growth and efficiency. However, even where the contracts are successful in stimulating output and efficiency, the "supply-side response" which is sought through these contracts may not materialize in the same years that revenue remission is granted, so that the authorities must coordinate revenue and expenditure po:Licy. 1.36 Many forms of the contracting system, especially those that allow enterprises to retain a larger fraction of total profits when output and prof- its expand, (sulch as the CMRS--see again Box 1.2) impart an elasticity of less than unity to the enterprise profits tax, thereby reducing the proportion of total profits transferred to the Government, and reducing the average tax/GDP ratio. Contracts designed with a decreasing average enterprise tax rate introduce a strong pro-cyclical aggregate demand element into tax policy. As production, profits and the economy grow, relatively more resources are kept by the enterprises to further increase demand.l1/ In contrast with other countries where the tax system is structured so as to restrain aggregate demand when the economy grows excessively rapidly, the stabilization effects of contracting in China could be said to be perverse. This would be less serious if, as noted earlier, the authorities had other effective macroeco- nomic instruments to control aggregate demand. 1.37 The contracting system in its wideLy applied CMRS version has also reduced the central government's flexibility to introduce new tax policies in a timely manner. This occurs because tax contracts--fixed for up) to 5 years- -set a nominal revenue level. Even if the contract itself were fixed for a shorter period (this could be undesirable in that it would increase uncer- tainty for enterprises), the fact is that most contracts are negotiated by the provincial and local governments which have no macroeconomic responsibilities, and which therefore pursue industrial, not stabilization objectives. 1.38 In the context of the present overheated economy, and especially because monetary instruments remain less than fully effective, the central government is vulnerable in this loss of control over fiscal policy. The government should refine the present tax contracting system, by building on its strengths while eliminating its weaknesses. The reform of tax contracting would seek to preserve those aspects serving microeconomic efficiency enhanc- ing objectives. Chapter II offers an approach to the refinement of the con- tracting system. As old contracts expire, future contracting would be limited to sharing of after-tax profits only. This would be akin to the payment of a "dividend" to the unit of government owning the enterprise. This would be appropriate because some part of the enterprise after tax profits derive from equity, provided hitherto at no cost, by the government.11/ By limiting the 10/ It could be said that these demand pressures exist whether the profits are reinvested or paid out as wages. 11/ The amount of after-tax profits which should be paid to the government (i.e., the after-tax contract share) is a complex matter and not dealt with in this report. The amount would depend, inter alia, on the value of the government's equity, risk, etc.  - 17 - contract to after-tax earnings, an important distinction of the government's two roles--as owner and as fiscal authority--would be achieved. 1.39 Decentralization. Fiscal decentralization has been a second factor affecting the control of the central government over tax policy for macroeco- nomic objectives. In China, the delegation to local governments of responsi- bility for tax administration, in the absence of effective central oversight, has put local governments in the position of setting tax policy and effective tax rates, through their authority to grant tax relief within their jurisdic- tions. This effectively severs the link between tax policy set at the central level, and the actual incentive effects of tax policy at the local level. 1.40 Moreover, because local authorities have an interest in stimulating economic activities within their territory, there are strong forces at work in the decentralized fiscal system against collecting tax revenues, particularly those that must be shared with the Center at a high rate, and in favor of keeping resources in the hands of locally owned enterprises through generous local tax exemptions. In this way, resources remain under local government jurisdiction which local authorities can tap through "voluntary" contributions that would not be shared with the central government. Thus, while the effec- tive "tax burden" of the enterprise is not reduced, budgetary revenue of the central government is eroding.12/ While the quota arrangement can--if the above-quota share is low--provide increased local government incentives to collect revenue and improve tax effort, it does not eliminate the potential conflict of interest between local and central governments, and by locking in a base revenue level, deprives the central government of a flexible revenue source. 1.41 Like enterprise contracting, the quota arrangement introduces a pro- cyclical bias to the fiscal system. This occurs because the revenue received by the central government under the "fixed remittance" quota system remains relatively constant regardless of the underlying growth of economic activity. Economic growth and activity affects only the revenues realized by the local governments (which feel the full fiscal impact of booms and busts). However since local governments do not have demand management responsibilities, they are likely to increase their spending when a booming economy produces higher revenues, and will not, as might the central government, try to dampen aggre- gate demand. In addition, the small above-quota revenue transfer that many contracts involve, and the fact that most are fixed in nominal terms have left an increased share of fiscal resources in the hands of local governments. This reduces the growth, and potentially the real volume, of resources in the hands of central government, a feature which as noted in Chapter III, must be coordinated with the respective expenditure responsibilities of the two levels of government. 12/ This approach also undermines the ability of the Government to conduct any sort of consistent national industrial policy. As observed in an earlier Bank report on state enterprise management (op. cit), the sharing arrangement on the enterprise income tax is also inimical to interprovincial mergers between enterprises. (See Kochav; D. China: Enterprise Management Report: Issues and Options;" October 18, 1988 (AS3).)  - 18 - 1.42 The reforms appear also to h,ave substantially changed the balance of revenues accruing to the central and local governments. Many indicators sug- gest that the revenue sharing system has led to a shift in favor of the prov- inces, which now retain a larger fraction of the revenues which t'hey collect. While this too is in line with the spirit of reforms and the decentralization of expenditures to the lower levels cf government, the failure to achieve corresponding reductions in the central government's expenditures has led to budgetary pressures. 1.43 The Chinese government must weigh the benefits of decentralization against the cost of having less capacity for central management and direction over tax policy. In order to gain more central management of revenue, expen- ditures, and stabilization policy, it will be necessary to reduce local gov- ernments' discretion over tax relief and monitor their tax administration. The status quo with regard to central and local finances appears untenable in the long run, and mechanisms need to be developed--some combination of new taxes for local governments, a reassignment of existing taxes or a different sharing of tax bases--to serve better both central and local interests. This is further discussed in Chapter III. 1.44 Finally, China's decentralized system of tax administration and col- lection weakens the effectiveness of the tax system as a tool for macroeco- nomic (or microeconomic) management. The decentralization of administration has left the government critically bereft of information about hoiw the tax system actually works at the grass roots level. This means that the link between tax pol:icy at the central level and the actual incentive effects of tax policy at the local level is severed. The "tax levers" the central gov- ernment designs may be a far cry from the fiscal measures which are actually implemented, leaving the central government significantly weakened in its use of a fiscal policy instrument. These issues are further discussed in Chap- ter IV. 1.45 Expenditure Issues. The uncertainty about details and timing of ongoing and planned reforms make the future development of government expendi- tures difficult to predict. This is so not least because the government's decisions on how t:o respond to shifting distributional patterns following the reforms will themselves be important factors in determining the outcome. Likewise, one cannot place too much reliance on a cross-country analysis to gauge the future ]Level of expenditures, because, in China, many economic and social functions which are usually the responsibility of the government, are now still carried out by enterprises. Much will depend on how many more responsibilities (such as investment financing) the government will relinquish to enterprises, and c'i whether and how soon the government will be pressured to take over new functions in the social area from enterprises. In this respect, the social security, housing and pension reforms should be designed from the outset with their budgetary costs in mind. If such precautions are not taken, it will be necessary to raise additional funds via the tax system to meet the higher. expenditures.13/ 13/ Two Bank studies are planned for FY89 which will examine the reforms in social security and housing and make recommendations as to their scope and financing.  - 19 - 1.46 Possible demands for government subsidy to such "social support sys- tems" highlight a key feature of the reform process. Reforms of necessity will create gainers and losers. The government, in seeking to blunt the impact of reforms on e.g. workers, enterprises, or urban residents affected by the transition, could possibly blunt the intended objectives of the reforms. Subsidies can insulate economic agents from such changes and neutralize the reform signals. Subsidy policy is therefore a concern, quite apart from its impact on the budgetary accounts. There are in addition severe risks to per- mitting the budget to respond to these demands for subsidies because of the higher expenditure they will call for and the authorities should strongly resist these pressures. Many countries have found it difficult to phase out acquired "rights" to subsidies, even when such subsidies are clearly inappro- priate. The choices the government faces, in this respect, will not be easy. 1.47 Extrabudgetary Revenues and Expenditures. In addition to resources from the budget, the Chinese government receives extrabudgetary revenues including the receipts of government units and government agencies that are not presently part of, and not consolidated with, the state budget. Extrabud- getary revenues of the government qua government were about Y 4.5 billion in 1987, or about 2-3Z of total budgetary revenue and 0.5Z of GNP (see Table 1.4 and footnote 8). These amounted to about 3.6Z of GNP. These revenues give rise to a number of concerns. First, to conduct fiscal policy effectively the government must have a true picture of its resources and the impact of the budget on the economy. Extrabudgetary and off-budget accounts and nonstandard presentation of accounts in China make managing fiscal policy through the budget misleading. Improvements in the Chinese presentation of budgetary accounts mentioned in Box 1.1 would show, for example, that the accounting practice of including past surpluses in "revenues" to finance incremental expenditures adds to the deficit and is expansionary, (or that financing expenditures with "revenues" acquired through sales of the state-owned housing stock are also deficit enhancing). Thus, the recasting of the budget to include off budget and extrabudgetary items undertaken in Box 1.1 shows the deficit to be more nearly 2.3Z of GDP than 0.5Z, in 1988. 1.48 Second, consolidated extrabudgetary and budgetary accounts would better reflect the true tax burden on enterprises, the economy's resource transfer to the government, as well as the government's financing needs. The present magnitude of the extrabudgetary revenues of government agencies helps to lend support to the allegation that while the accrual of formal taxes to the government has fallen, the actual burden of taxes together with these extrabudgetary charges on enterprises has not decreased, and that there may even be a significantly increased tax burden on enterprises. Indeed, at pres- ent levels, the extrabudgetary revenues accruing to government agencies are equivalent to an increase in the enterprise income tax rate from its present effective rate of about 49Z to a rate more nearly 67Z.14/ 1.49 Tax Reform and Budgetary Correction. Rising inflationary pressures have highlighted the concern that corrective budgetary measures and the tax changes they could involve will add to costs as enterprises attempt to shift 14/ To the extent that the extrabudgetary revenues represent fees and charges for services, they should be considered revenues from user charges, and would not reflect increased drawbacks from enterprises.  - 20 - these forward to prices. This may create cost-push pressures throughout the economy, pressures which may be seen as enhancing rather than containing the inflation process.151 1.50 A distinction between the pice-level effects and the demand dampen- ing anti-inflationary consequences of taxation must be drawn. Inflation is a continuous process arising from a steady pressure of aggregate demand over the available resources that may be rooted in or be compounded by a fiscal deficit and its financing. Fiscal measures aimed at reducing the budgetary gap, to the extent they significantly and permanently reduce the budget dieficit, will reduce the cont:inuous pressure on aggregate demand, with a consequent reduc- tion in inflation. If in addition, fiscal reforms enhance efficiiency and provide incentives to increase productivity--a major objective of tax reform in China--aggregate supply will be increased, further reducing inflation. 1.51 The distinction which should be drawn therefore is between constant and permanent upward pressure on the aggregate price level arising from fiscal imbalance and a once-and-for-all change in relative prices caused by correc- tive budgetary measures. In China as elsewhere, continuing deficits will exercise a constant pressure on the aggregate price level, and are likely to be inflationary!, if not offset by monetary restraint. Tax changes that reduce budgetary imbalances will dampen inflationary pressures, not increase them. Certain tax reforrm measures, e.g., an increase in VAT rates, will result in a one-time rather than continuous price level increase provided appropriate monetary policies are pursued. This highlights the importance of maintaining the appropriate monetary policy at a time of structural change in China. Likewise, revenue gains must be accompanied by expenditure restraint so that any revenue gains are not offset by expenditure increases. D. Conclusions l152 The analysis of budgetary trends suggests there are forces at work in the system that may bring about fiscal pressures. Looking ahead, on the reve- nue side the Chirese authorities may find it difficult to prevent a continuing decline in the tax/GNP ratio in a system in which taxes are subject to case- by-case negotiation as under the contract responsibility system. The negotia- tion process is likely to lead to declining effective tax rates since the enterprise will bargain only if it is likely to retain an increasing propor- tion of profits, that is, if it will do better than under the syst:em of a fixed profit tax. Decentralization of fiscal authority has weakened collec- tion effort. Consequently, unless measures are taken to reestablish the buoy- ancy of the tax system, the declining trend in revenue will continue. On the expenditure side, the consequences of the ongoing reforms are less clear. The outcome will depend in large measure on government's ability to resist pres- sures for higher subsidies vs. the rate at which expenditure responsibilities are divested to nongovernment units. An expenditure elasticity of much below unity is, arguably, not unlikely as a longer run estimate. 1.53 As China moves toward a market economy, the need for fiscal policy to play an effective macroeconomic and efficiency promoting role is iincreasing 15/ Chapter II indicates that for goods sold in free markets, such forward shifting is likely.  - 21 - and therefore the erosion of flexibility and control over tax policy instru- ments inherent in the present system needs to be addressed. The authorities' objectives of stimulating growth, maintaining stability and enhancing equity can only be achieved by means of a system which is flexible and offers the certainty necessary to allow the tax system to be used as a policy instrument. The Chinese tax system is becoming perilously weak in this respect, and its enhancement as a policy tool for macroeconomic management needs attention. 1.54 This being said, by contrast with other developing countries, China's tax and expenditure system betrays few of the salient weaknesses exhibited by countries where fiscal deficits have been at the root of macroeconomic crisis, inflation, external indebtedness and trade disequilibria. However, it is at the microeconomic level that China's tax policy exhibits significant weakness. There are significant efficiency gains to be had from tax reform; these are reviewed below. The next chapter examines them in more detail. 1.55 China's tax system is complex and highly personalized. A negotiated basis for taxation is increasingly incompatible with China's emerging market system. Since reforms enhance the responsiveness of enterprises to tax incen- tives, the price signals given by the tax system are of increasing importance. Domestic tax-inclusive prices must be rational if decentralized decision- making is to be efficient. The continued commingling of government roles vis- a-vis the enterprise, exhibited by China's tax system must also be effectively separated. A system which effectively sets tax rates on an enterprise by enterprise basis is costly and increasingly inconsistent with certainty requirements under enterprise reforms, biasing the tax system in favor of random enterprises in an unpredictable way, and encouraging enterprises to focus on tax negotiation, rather than productivity, to produce profits. The profusion of indirect taxes also complicates the rebating of taxes on exports, and with accession to GATT in mind, Chinese officials are rightly concerned. The connection between price, tax and enterprise reform is further pursued in Chapter II. 1.56 In summary, China should not adopt a tax reform merely for revenue raising purposes alone--the most important benefit of a tax reform would come at the level of microeconomic efficiency including the efficiency gains to be derived from broader based taxation of state enterprises at lower rates. Some taxation of growing surpluses in the nonstate sector and the household and agricultural sectors is also essential not only for longer run equity objec- tives but for perceived fairness and burden sharing. Finally, the efficiency gains from a reduction in bargaining behavior by enterprises, in an environ- ment where taxes are no longer negotiated, should not be underestimated.  - 22 - II. REFORMING THE TAK STRUCTURE A. Key Features of China's Present Tax System 2.1 China's tax system is a unitary one, meaning that taxes, the tax base and tax rates are determined by the central government and there is no taxing authority other than the central government. The main revenue raising indi- rect taxes are now the value added tax (VAT), product tax, and business tax. Indirect taxes that raise smaller amounts of revenue include customs duties, Resources Tax, Salt Tax, Urban Construction and Maintenance Tax, Fuel Oil Tax, Housing Tax, Livestock Sales Tax, Market Transaction Tax, Slaughter Tax, Real Estate Tax, and Vfehicle and Boat Tax. Direct taxes raising significant reve- nue are the state enterprise income tax, transportation and enerlgy charge, extrabudgetary construction tax, and collective enterprise incomie tax. The personal income adjustment tax raises little revenue but, as income rises, can be expected to become a more important component of the direct tax system. 2.2 This chapter examines the main revenue-raising taxes from the per- spective of the key role that they play in the overall process of economic reform in China. Section A of this Chapter describes China's tax system as of 1988, while Sect:ion B analyzes the impact of the current fiscal regime on the (micro) economic decision-making in the economy. Section C outlines the report's recommendations for tax reform in the areas of indirect taxation, enterprise taxation, and taxation of individual incomes. The revenue and efficiency imp:Lications of the tax reforms are considered. A matrix summa- rizes the tax reform recommendations and highlights the fact that their intro- duction and sequencing depends on progress made in other areas of reform. The Tax System in 1988 The Structure of Enterprise Taxation 2.3 Prior to 1978 enterprises remitted all profits to the budget. Exper- iments with the taxation of state enterprises began in 1978 and involved the substitution of taxation for full profit re;mittance. Reforms in state enter- prise profits distribution had as their main objective the improved efficiency of state enterprises. By 1980, the trial system of profit retention and taxa- tion was being applied to over 6,000 enterprises, representing over 60Z of the gross value of industrial output. As a result of these experiments, a system of direct taxation was introduced, implemented in two stages. First, and in parallel with the quota responsibility system of enterprise mana,gement, a formal income tax was imposed on all state enterprises, but 'profit sharing' continued to be applied to the remaining after-tax profits. The second stage eliminated profit: sharing altogether and put full reliance on the income tax, levied at a rate of 55Z, for virtually all state enterprises by 1983/4. 2.4 In addition, an "adjustment tax" was imposed on the net after-tax profits of all medium and large state enterprises so that in its initial stages, the system remained similar in substance to profit remittance. The objective was to prevent excessive deviation of enterprise profit margins from their 1983 (prereform) levels. The adjustment tax helped to equalize profita- bility across enterprises within a sector, since, as noted in Chiapter 1, the  - 23 - differential structure of VAT-cum-product taxes could only achieve equaliza- tion on an across-sectoral basis, and it was administratively determined for each enterprise on an individualized basis. 2.5 The changes in China's profits tax system were, in this respect, consistent with the changing role of taxation toward a "guidance," as distinct from "command," mechanism. The Chinese system, with its "adjustment tax," was distinctive, but the approach followed that of other socialist economies which, in the course of reform, have also had to adjust the division of prof- its between the state and the enterprises. 2.6 Direct taxation of enterprises at present varies according to the type of business organization being taxed. The taxes applying to the five main types of business--state enterprises, collective enterprises, individual household enterprises, joint ventures, and foreign enterprises--are described below. Taxation of profits varies according to type and size of the enter- prise and, in certain cases, its location. State enterprise are also subject to various levies on after tax-earnings. 2.7 State Enterprise Income Tax. State enterprises are divided into three categories for tax purposes. Large and medium-sized enterprises pay, in principle, a flat tax rate of 55Z on their taxable profits. Small enterprises use an eight bracket progressive structure with rates ranging from 1OZ to 55Z. Industrial and commercial enterprises use different tax returns entailing differences in the calculation of taxable income. Enterprises engaged in catering and service trades, profit-making guest houses, restaurants and hotels used to pay a flat profit tax rate of 15Z; they are now subject to the small-scale enterprise profits tax. Banks, until mid-1988, remitted most of their profits to the budget; they are now subject to profits remittance tax or a form of the contracting system described in Chapter 1.1/ 2.8 Taxable income equals enterprise income minus "allowable business costs." Figure 2.1 shows how the definition of taxable income is reached, and indicates the allowable business costs and taxes which are deductible from income on arriving at the taxable base. Depreciation of fixed assets is an important deductible cost. Before 1985, a "comprehensive depreciation" method was used, where all fixed assets were depreciated at the same straight-line rate. In other words, no distinction was made between buildings, machinery, equipment, and vehicles. After 1985 the method of "categorized" depreciation was introduced on a trial basis with differentiated schedules according to type of asset. Depreciation in China is an actual cash expense, in that it must be paid into a "depreciation fund", maintained at the Industrial and Commercial Bank, where it must be held for a minimum of three years. This makes depreciation different from other countries where it is a noncash deduc- tion from income. 1/ Specifially, banks are allowed to retain 7Z of their profits; of the remainder 55Z is taxed, 45Z are remitted. Further details of each of the other types of tax can be found in Appendix Table 3. A complete schedule for the Chinese tax system is provided in Annex 1.  - 24 - Figure 2.1: ALLOCATION OF GROSS INCOME Gross business income plus other incorne minus Sales Tax Technology Transfer Tax Business managernent fee minus Product cost Other expenses minus Interest on debt: Repayment of principal Depreciation equals |Taabeincome | minus equals Income Tax payable Adjustment Tax fEor large and medium-sized enterprises equals After-tax income plus fontribution to depreciation fund equals 3ase for transport and energy charge minus Transport and energy use a3 equals Funds available for Enterprise disposition and allocation of Net Income (see Figure 2.2)  - 25 - The depreciation fund is an important component of enterprises' "own funds". Repayment of loan principal (on investment loans) is also an important deduct- ible cost. This allowance has its origins in the grant financing of invest- ment which prevailed until 1981. When grant financing was superseded by loan financing the tax system was then used to accommodate the higher cost to enterprises by allowing full offset of principal repayments from tax.2/ 2.9 The Contracting System for State Owned Enterprises. Income taxation of state enterprises can be substantially altered by the tax contracting sys- tem. The approach was modelled after the "responsibility system" for agricul- ture, and is an important instrument of industrial policy. Contracts are signed between the enterprise and the Finance Department and cover items such as profit or tax delivery, investment, innovation, and wage policy. It takes the four broad forms described in Chapter I (Box 1.2). The general idea of tax contracting--from the taxation perspective--is straightforward and in the CMRS variant, applying to some 60-70X of state enterprises, requires an enter- prise to deliver a "tax or taxable profit quota," in lieu of income and adjustment tax. As described in Chapter I, the marginal rate on "above quota profits' or above quota taxes can differ across enterprises--some enterprises keep 10OZ of the excess. The contracted profit or tax amount is determined in various ways, and may be tied to previous year's profits or determined by competitive bidding. 2.10 Some enterprises do not meet the profit contracts specified. In such cases, the shortfall is supposed to be made up out of enterprises "own funds", that is, their accumulated past retained earnings and depreciation funds. In practice, enterprises do not always make up the shortfall. Banks may forgive, or forego payment on loans, and the Finance Department to whom the tax is owed may in certain cases absorb the budgetary shortfall. In addition, enterprises which fail to meet contract targets because of unfavorable price changes can appeal to the Finance Department for revision ex post of the contract, on "objective" grounds. Contracts can also include contracts for agreed losses. 2.11 Both these formal and other less formal adjustments to the contracts appear significantly to reduce the effective rate of income tax from the sta- tutory 55Z. Justification for such reduced income tax rates lies in the per- ceived need to provide tax preferences at the start-up stage, or for an enter- prise for whom payment of taxes (direct or indirect) would otherwise mean losses. 2.12 Adjustment Tax. Large and medium-sized enterprises face the "adjust- ment" tax that varies from enterprise to enterprise. It is intended to claw- back from enterprises that part of their profits which accrue from distorted input and output prices, and unequal capital endowments. To the extent that excess profits arise from the latter it is therefore a proxy for dividends which enterprises endowed with state capital should pay. Although it was intended to be temporary and phased out beginning in 1986, the tax continues to be paid by many large state-owned enterprises not subject to contracts. 2/ Since 1987, the phasing out of this provision, beginning with "technical transformation' loans, has been under consideration.  - 26 - Figure 2.2 Allocation of Net Income IContriutions to 5 Funds minus minus Extrabudgetaxry Wage Bonus Tax Construction TEIX Wage Adjustment Tax 1. ProductiorL 5. Workers' Bonus Fund Development Fund 2. New Product 4. Workers' Welfare Fund| Development Fund l eserve F 2.13 Energy and Transport Charge (Also sometimes referred to as a fee or tax). Enterprises' earnings after payment of income and adjustment tax, are used to pay a transportation and energy tax or fee of 15% on the sum of after- tax earnings plus depreciation. 2.14 Other Taxes on Net Income. The enterprise's net after-tax earnings are subject to fEurther taxes. To determine the actual taxes duie, after tax earnings are divided among five funds: (i) a "new product development fund"; (ii) a 'production development fund"; (iii) a reserve fund; (iv) a workers' welfare fund; and (v) a workers' bonus fund (See Figure 2.2). The main requirement is! that 602 of after-tax earnings go to the first three funds, while not mores ithan 40X may be paid into workers' welfare funds or bonuses; the actual percentage is usually more. 2.15 The extrabudgetary construction tax is levied at 1OZ on construction financed by entesrprises' retained earnings and undertaken outside the state investment budgiet (mostly buildings). Certain construction is exempted from this tax, suchi as in energy and transport facilities, medical facilities, schools, and investments financed by joint ventures and foreign enterprises.  - 27 - 2.16 A progressive bonus tax is applied when bonuses exceed a certain proportion of wages, set at four months wages, in 1988. A progressive wage adjustment tax is also applied to wage increases exceeding a certain rate--7Z in 1988. Both taxes are paid from the wage bonus fund, in that the contribu- tion from after-tax earnings into the bonus fund is reduced by the amount of these taxes. 2.17 State Enterprise Income Tax: Small Enterprises. The profits tax on small SOEs is levied according to an 8-stage progressive scale with rates from 10 to 55Z. As with all multibracket schedules, the tax rate is applied to each bracket of income separately, i.e. income in the lowest bracket is taxed at the lowest bracket rate of 10%, income of the next bracket is taxed at the next higher rate of 20%; etc. 2.18 The profits taxes on state enterprises are collected by local author- ities (typically the county), and accrue in principle, to the level of govern- ment which "owns' the enterprise. While all state enterprises in China are, in principle, owned "by the whole people,' in practice, this ownership is effected through government units at central, provincial and local levels. Thus, if the enterprise is owned by the central government, the county-level tax authorities will remit such taxes to the central government. If the enterprise is owned by the province, revenues will be remitted directly to the provincial authorities. 2.19 Collective Enterprises Income Tax. This was introduced in 1984. Taxable income equals collective enterprise income minus business costs and indirect taxes. Allowable business costs differ from those for state-owned enterprises. For example, repayment of loan interest and principal, though certain approvals may be required, are in practice deductible expenses for both capital construction and transformation loans, but usually only to the extent of 602. Income tax is computed from an eight bracket progressive schedule, identical to that on small state enterprises, with rates ranging from 1OZ to 55%, and start-up tax holidays are common. 2.20 Individual Household Enterprises. The individual household enter- prise income tax was introduced in 1986 and is designed to tax the wide and growing range of small private businesses which make up this sector. Individ- ual household enterprises face a ten bracket progressive schedule with rates rising from 7Z to 60Z on taxable income which equals business income, minus costs and indirect taxes. A surtax of 1OZ to 40% of the tax liability is imposed on income exceeding Y 50,000. 2.21 Joint Ventures. The joint venture income tax is levied on net income derived by joint ventures, including income from branches inside or outside China. The income tax rate for the foreign partner is a flat 30Z with an additional local surtax (on the tax liability) of 1OZ, bringing the total rate to 33Z. A foreign tax credit is allowed for income taxes paid to other coun- tries by joint ventures and their branches. Remitted profits are subject to a 10% levy. Generous tax holidays are provided in the initial years of opera- tion. The Chinese partner is liable for the applicable enterprise income tax. 2.22 Foreign Enterprises. Foreign enterprises are those foreign compa- nies, enterprises and other economic organizations having establishments in  28 - China engaged in independent business operation or joint production with Chinese enterprises. Income tax is calculated at progressive rates ranging from 20 to 40%. A local income tax of an additional 10% of taxable income is also levied, bringing the top marginal rate to 50Z. 2.23 Resource Tax. The Resource Tax was introduced during the reform of enterprise taxation to equalize profitability between enterprises with differ- ent access to natural resources. In principle, all coal, oil, gas and miner- als enterprises pay this tax, but in actuaLity it is applied to enterprises that use coal, oil or natural gas, at different rates for small and large enterprises (and according to collective and ownership). The provision for it to be applied to minerals has not been implemented. The rules currently exempt enterprises with a profit rate (defined as return on sales) below 12Z, and tax earnings between 12Z and 20% at 50Z, those between 20Z and 25Z at 60%, and profits over 25% at 70%. Because of the volatility in profitability from year to year, the tax is in practice levied at enterprise-specific rates, relating to rate of extraction and resource quality. To the extent that this tax is levied on sales, it can be viewed as an indirect tax. The Taxation of Individual Incomes 2.24 The PEetsonal Income Tax. The individual income tax law, introduced first in 1980, applied to both foreigners and Chinese citizens but was mainly designed to taLx foreigners. Exemption levels were many times higher than the average Chinese wage. Generally, any individuals residing for one year or more in China are taxed on income gained within or outside China, although those resident for 5 years or less are taxed on foreign source iincome only if it is remitted. In practice, foreigners not intending to become permanent residents are not taxed on foreign-source income. Following the introduction of the PIAT (see below), this tax applies only to foreigners. Rates are pro- gressive. Dividlend or interest payments made abroad are subject to a 20% withholding tax. Dividends and interest received by foreign residents of China are not taxable. 2.25 The Personal Income Adjustment Tax. This new tax parallels the per- sonal income tax described above and was introduced in September 1986 in order to address the growing numbers of Chinese citizens receiving substantial incomes. (In Beijing, 1Z of all income earners now pay this tax.) It raises a small amount of revenue now but is expected to grow in importance. The tax is assessed on individuals, rather than households, and no allowance is made for the number of dependants. The tax is computed on a monthly basis with amounts above Y 400 per month taxable; income cannot be averaged between months. Income in kind is, in principle, subject to tax but sirLce this is not administratively feasible, no attempt is made to do so. There aLre no plans, for example, to tax the cash housing subsidies that are being paid under hous- ing reform or other reforms. The Structure of Domestic Indirect Taxation 2.26 Up to 1983 the indirect taxation of enterprises was carried out through the Consolidated Industrial and Commercial Tax (CICT), the precursor of the Product Tax, VAT and Business Tax. This tax, introduced in 1958 and  - 29 - simplified in 1972 was a turnover tax that was applied to industrial produc- tion, some agricultural sales, imports, retailing, transport and communica- tions and services. 2.27 The CICT was replaced in 1984 by the Product Tax (a multilevel sales tax on manufactures), VAT, and Business Tax (levied on gross receipts in the service and selected other sectors). The restructuring of taxes on production was a consequence of the change from profit remittance to profit taxation for state-owned enterprises. Under profit remittance, the fact that prices did not reflect costs of production was not very important. However, under profit taxation enterprises kept a certain proportion of their profits, and since the pricing system could generate considerable profit differentials between enter- prises, this had consequences for their investment and growth prospects. This inequality could have been reduced by price reform, but instead it was decided to use product taxes to offset the inequities arising from distorted prices. As the price of a good to its purchaser was fixed, an indirect tax could be used to reduce the price received by the producer and thus reduce excess prof- its. The main consideration in setting product tax rates in 1984 was to equalize profits (as a proportion of sales value) between products, with some modifications to encourage or discourage the production of particular goods. This approach led to a very large (over 260) number of different indirect tax rates. Product tax, VAT and business taxes continue to be the major indirect taxes. The VAT has increased in overall importance (it contributes 26% of all indirect tax revenue), and now covers all but three subsectors of the economy, largely supplanting product tax. 2.28 Product Tax. Product tax is levied on the manufacture and import of certain goods. The tax base is the value of goods sold, valued at the prices paid by the purchasers. Thus, the effective price received by the producer is equal to the purchase price minus the tax. This differs from normal interna- tional practice, where tax is expressed as a percentage of the producer price and then added to the producer price in order to determine the price paid by the purchaser.3/ This distinction is important in interpreting tax rates. To take an example, the tax rate on tobacco products is 60%, meaning that for every Y 100 paid by purchasers, Y 60 is paid in tax and Y 40 is kept by the producer. The tax paid is, therefore, 150Z of the producer price and a 60X product tax rate translates into a sales tax rate (normally defined) of 150%. 2.29 The substantial variation in product tax rates is due to the use of the tax system to offset the effects of distorted prices and constitutes a major difference between the Chinese tax system of indirect taxes and the systems in use in other countries. Appendix Table 3 illustrates the range of rates which range from 3% to 60%. Notwithstanding this difference, the struc- ture of rates shows certain similarities with international practice, with the application of especially high rates to tobacco and alcoholic beverages and 3/ The apparent reason for this is that the (controlled) purchaser price is known and fixed and therefore represents a clear benchmark on which to assess the tax.  - 30 - gasoline. Taxies on these three groups of products raised 27Z of total product tax revenue in 1,986.4/ 2.30 Value Added Tax. The Value Added Tax (VAT) is gradually replacing Product Tax as the major tax on manufacturing and imports. The replacement is carried out in such a way that while both taxes together cover all manufac- tured goods, no product is simultaneously liable to both. VAT riates have been set on a product-by-product basis, with rates set to yield the same absolute amount of revenue as the Product Tax it replaced.5/ The nominal rates of VAT are correspond:ingly higher than the product tax rates, to maintain the same absolute level oif tax liability and to prevent changes in profits from taking place as a result. of the tax shift. This means that there is also a large number of VAT rates. VAT is not applied to agriculture, services, construc- tion, transporlt, communications or wholesale and retail distribution. Exports are zero-rated in keeping with general international practice. 2.31 As with Product Tax, VAT is applied to the purchase price of a good, not its producer price. The difference from product tax is that under the VAT taxes paid on intermediate inputs into production are presumptivesly credited. VAT rates range from 12Z to 45Z. (See Appendix Table 3). 2.32 The coexistence of Product Tax and Value Added Tax is unusual: most countries that have adopted VAT have made a complete switch all at one time. The large number of different VAT rates is also unusual and, as with the Product Tax, arises from the distorted price system. Both of these features of the Chinese tax system cause considerable difficulty in administration. 2.33 In principle, each enterprise should be credited with both the prod- uct tax and the! VAT that has actually been paid on the intermediate inputs that it has bought. However, in practice, the credit for inputs that have paid Product TaLx is made at a composite, or "presumptive" rate of 14Z. For some enterprises this composite rate is extended to include all intermediate inputs, including those that have paid VAT. This practice--known as "presump- tive crediting"--,is administratively attracitive when firms purchase a range of inputs that have paid product tax and VAT at different rates or when it is difficult to ascertain the taxes paid at earlier stages, as in China where invoices do not show taxes paid.6/ Thus, the operation of the Chinese VAT differs in several respects from the standard invoice method. 2.34 VAT in China does not allow credit for tax paid on purchases of fixed assets. In other words, the tax is gross-product based in contrast to the 4/ Calculated from data provided by the GTB. 5/ But see para. 2.78 on the use of taxes for industrial policy and the tax burden on textiles. 6/ Presumptive crediting is also admninistrative:Ly attractive as it allows purchasers to credit tax which inputs should but may not have paid, due to the local policy of providing tax preferences and exemptions.  - 31 - more widely used consumption-type VAT, and less widely used income VAT.7/ Exporters of manufactured goods receive rebates of VAT to effect the zero- rating of exports. 2.35 Business Tax. Business Tax replaced that part of the Industrial and Commercial Tax that applied to wholesale and retail distribution, construc- tion, transport and communications and services, including financial services. It is levied as a turnover tax on gross receipts in all nonagricultural sec- tors apart from wholesale, where it is applied to the gross value of the markup (See Appendix Table 3 for rates). Because of the difficulty that China, like many countries, encounters in dealing with large numbers of small businesses, sales below a certain monthly figure are exempted. Additional exemptions are allowed on a discretionary basis, and some items are subject to half-rates. To facilitate administration, a surcharge is sometimes imposed on wholesalers in lieu of taxation of retailers. Other Indirect Taxation 2.36 Agriculture tax is levied on agricultural households on the basis of the normal yield of their land. This normal yield is defined in terms of grain valued at the prevailing procurement price and based on the general land quality in the area. The tax rate is set by each province and, in the absence of frequent surveys, underassessment is common. Up to 1983, grain producers typically paid the tax in grain, while nongrain producers paid it in cash. Agricultural households are not liable for Personal Income Adjustment Tax, Individual Enterprise Income Tax, Product Tax, VAT or Business Tax. Because the tax is levied on gross output, it bears no direct relation to income, except that exemptions can be granted for exceptionally poor households and widows, and during natural disasters. Because the tax is based on normal grain yield, usually assessed based on crop-yields set in the 1950's, it takes no account of the fact that some land is more suitable for growing higher priced crops, such as vegetables. It is also, therefore, not equivalent to a tax on land value. Local government surcharges are levied on the agriculture tax and there is considerable variation between counties in the combined rate. In 1989, a tax on the value of nongrain output; with rates ranging from 10-30Z was introduced. Accordingly, high-yield products which encroach on grain farming could be taxed as much as 30Z. 2.37 Taxes on Imports. The "open door policy" was initiated in 1979 and a new customs policy was introduced in 1984 to encourage exports and imports of necessities, at the same time as protecting domestic industry and maintaining customs revenue. The new customs duty structure was designed to facilitate imports of major inputs that were not produced domestically, including raw materials, spare parts, fertilizers and equipment. It also protected domestic manufactured goods, especially those for which domestic production was regarded as important. Import duties range from 3Z to over 1002, levied as a proportion of their c.i.f. price. Product Tax or VAT (as appropriate) is then applied to the duty-inclusive price of the import. The product tax and VAT rates are the same as for domestic production of the good concerned, and the tax is calculated to be the required proportion of the tax-inclusive price. 7/ Only Morocco and Finland apply the so-called "gross-product VAT,' while only three developing countries apply the "income VAT;' See Tait, op. cit.  - 32 - The symmetric treatment of imports and domestic production accords with inter- national practice. Exemptions from duty are sometimes granted to compensate enterprises for increases in world prices. 2.38 Taxes on Exports. Export cluties are levied on the export of a few raw materials (foodstuffs, and more recently silk) where China has some mono- poly power. Revenues from these duties amount to no more than 3Z of total customs duties or 0.3Z of total tax revenues. Other Minor Taxes 2.39 There are a number of other taxes that yield small amounts of reve- nue. Some of them are central government taxes, such as the Salt Tax and the Fuel Oil Tax. Others are purely local taxes, such as the Urban Construction and Maintenancie Tax, Livestock Sales Tax, Market Transaction Tax, Slaughter Tax, Real Estate Tax and Vehicle and Boat Tax and Banquet Tax. In addition, there are surcharges on the joint venture income tax, the foreign enterprise income tax, and, as noted earlier, the agriculture tax. These taxes can pro- duce important rievenues for local governments but are not, from the overall revenue perspective, significant taxes. Together, they contribute less than 27 of total revenues. These are discussed in detail in Chapter III and Annex 2. Implicit Indirect Taxes 2.40 The reform of indirect taxation was accompanied by the introduction of the dual pricing system in 1985/86. This allowed enterprises to purchase part of their inputs and sell part of their output at market prices. However, State enterprises must first deliver their plan quota at State list prices before selling ouitput on the free market, and may also buy inputs necessary to fulfill plan targets at list prices. The proportion of consumer goods trans- acted at list prices has fallen from 97% to 47Z over the period 1978-1986. Out of the 53Z oiE transactions in consumer goods not occurring at State list prices, 19Z took place at 'guidance" prices and the remaining 34Z at market prices. For intermediates as a whole, guidance and market prices currently make up about 40Z of all sales and that the proportion is increasing.8/ The system of price controls can be seen to be an implicit subsidy to users, financed by an implicit tax on producers. Some illustrative orders of magni- tude are presented in the following section. 8! Evidence oni the extent of plan vs. market sales is fragmentary; selected data suggests that a large fraction of consumer goods is transacted al: market prices, while for some intermediates free market sales are negligible; for intermediates generally, market prices appear to make up over 40% of all sales. See Annex 1 for the proportion of sales at free and official prices, and an extended discussion of the implications for tax shifting. Turning to individual items, selected data on constumer goods suggests that the proportion of retaiL sales transacted outside State-owned commercial departments ranged from (5%) for grain to (452) for television sets in 1987. For universal intermediates, out-of-plan transactions appear to be virtualLy negligible for electricity and crude petroleum, between 15 and 20X for steel and coal and around 50% for cement.  - 33 - B. The Impact of the Current Fiscal Regime 2.41 This section examines the incentive, equity and other effects of the major tax categories in China: indirect (product and VAT) taxes; the enter- prise income tax, and the resource tax. The effects of trade and personal income taxes are touched on briefly. Indirect Taxes 2.42 At a microeconomic level, taxes affect almost every decision enter- prises make. Indirect taxes affect input and output prices faced by enter- prises. However, the impact of such price changes on enterprise behavior and the effectiveness of indirect taxation as an indirect lever depends on a num- ber of factors. First, there is the question of how much discretion the enterprise has in choosing output level, output mix and production techniques. Second is the proportion of its output the enterprise sells on the free and controlled markets. If all production choices are imposed by the planning authorities, the incentives offered by the tax or price system are irrelevant. For example, if the bulk of China's foreign trade continues to be determined by planning, the effect of customs duties on foreign trade corporations will be quite limited. 2.43 The evidence from enterprise studies suggests that state enterprises increasingly have the freedom to choose output levels and production tech- niques and that the change from profit remittance to profit taxation has increased their responsiveness at the margin, to profitability considerations and tendency towards behavior in accordance with market rules.9/ This is particularly true of sales on the free market. The market economy enhances the responsiveness of State-owned enterprises to tax instruments: inasmuch as State enterprises can sell additional output on the free market, it is the tax (or price) incentive on free market sales which will determine an enterprise's profit-maximizing choice. The incidence and incentives of the tax system therefore will be influenced by the combination of plan and market sales that characterize different sectors of the economy. 9/ Evidence from enterprise studies suggests that managers "are driven by a desire to increase benefits to enterprise employees... The main avenue for pursuit of these ultimate objectives was increased profits." (quotation from Perkins, op. cit.) See also W. Byrd et. al. Recent Economic Reforms: Studies of two industrial enterprises. (World Bank Staff Working Paper No. 652, 1984) and W. Byrd and G. Tidrick, "Factor Allocation in Chinese Industry," Paper prepared for conference on Chinese enterprise management, Beijing, August 1985. The increase in the 1980s in the proportion of profits that enterprises are allowed to retain for their own use is seen as having contributed to such an orientation on the part of managers. Evidence from such studies also suggests that contracts increasingly call for a choice of production technique to be determined in the context of the contract. This suggests choice of techniques is an important feature in the contracting system, also and that there is some choice of techniques. See Perkins, D., "Reforming China's Economic System," Journal of Economic Literature, June, 1988.  - 34 - 2 44 Implicit Subsidies. The system of price controls is an implicit subsidy to users, at the expense of producers. Price controls on final goods subsidize consumers at the expense of the producing industries, while price controls on inputs boost the profitability of consumer goods producing enter- prises at the expense of those producing inputs. Since indirect taxes are levied within the overall framework of price controls, taxes and prices must be viewed as an integrated system. 2e45 The subsidy implicit in price controls on final goods can be tenta- tively calculated as follows: A broad estimate of the subsidy implicit in the difference in market and official prices is represented by the difference between officially reported "urban market prices" and "state list prices." On average, controlled prices were 8Z less than prices for market "goods for daily use" and :30% below for "other goods" in 1987.10/ Since about 70Z of "daily goods" were sold at state-list prices, under the assumptions above, the average price of all "daily use" goods is lower by 5.6Z.11/ For "other goods", 60X of the sales took place at controlled prices 30% below market, so that average prices were lower by 18Z. With "daily use goods" accounting for approximately 1Z of retail sales, while "other goods" account for approxi- mately 36Z of retail sales, the effect of controlling these prices on an index of retail prices is approximately 7%. 2.46 Impact on Profitability. The system of price controls and taxes also affects enterprise profits. With output targets specified and plan prices fixed, the State-controlled price system is an implicit tax on producers of goods subject to price control. Faced with these prices (and implicit taxes), the tax authorities then set indirect tax rates in order to generate producer prices (i.e., pLan prices less explicit taxes) that allow enterprises to earn "reasonable" profits. This, in turn gives rise to China's sectorally differ- entiated structure of indirect tax rates. For plan sales, therefore, the differentiated indirect tax structure has no impact on purchaser or user choices; these will be influenced by the administered price system. The effects of indirect taxes are, in the first instance, confined to enterprise profitability alone. Indeed, tax rates are explicitly set to reproduce profit margins prevailing in 1983. 2.47 Second, in sectors subject to controlled prices, indirect taxes bear directly on enterprise profits. The 1984 tax reforms set those rates to equalize profitability on sales (ROS). However, profitability on sales that forms the basis for tax policy bears little relationship with profitability on fixed assets or rieturns on equity that market economies seek to equalize. For example, profits in the ferrous metal industry (defined as return on sales) are well above thie national average, making that industry a candidate for heavy indirect taxation. In contrast, profitability in relation to assets is below the national average; thus, taxes set with reference to return on sales lO/ The discuss:ion here focuses on nonagricultural goods only in as much as the analysis of indirect taxes addresses only nonagricultural goods. See Annex 1 for details. 11/ Seventy percent of these goods are underpriced by 8%; the remaining 30Z are not under priced. Therefore the average rate of subsidy would be 5.6Z.  - 35 - will make profits in relation to assets, and therefore funds for reinvestment and growth, unduly low in that industry. 2.48 The ROS measure of profitability is especially problematic when con- sideration is given to the principal uses to which after-tax profits in state- owned enterprises are put. An enterprise's need for retained funds for expan- sion depends on its capital-intensity and rate of growth; funds needed for worker benefits depend on the number of workers. Given that retained earnings financed some 38% of investment in 1986, equalizing sales profitability can starve capital-intensive industries of funds for expansion; indeed, this was observed to be particularly marked in railways and electricity, leading to the reduction in business tax on railways in 1986 and a change in the tax rules for electricity to allow more costs to be deducted for tax purposes. By the same token, labor-intensive industries have found it more difficult to afford bonuses than less labor-intensive industries. 2.49 In contrast to the above, indirect tax rates have a very different incidence on transactions occurring outside the plan price system. For such transactions, a differentiated rate structure is likely to be shifted forward and reflected in consumer prices and thus discourage the purchase of rela- tively highly taxed goods. In those cases, the differentiated tax structure is likely to create adverse incentive effects. While some differentiation of the tax structure is desirable in a market economy (e.g., to tax luxury goods or socially harmful goods), the differentiation required on such grounds bears little relationship with that set by the Chinese tax authorities to equalize sectoral profitability. Objectives of differential taxation in market econo- mies can usually be achieved by setting particularly high tax taxes on a small number of particular goods, rather than by highly differentiated taxes across the whole range of industrial products. Excessive sectoral differentiation in China has distortionary effects that depend inter alia on the proportion of sales transacted at market prices. 2.50 In sum, the effects of tax changes are very different on plan trans- actions and free market sales. A tax increase will reduce enterprise profita- bility to an extent that depends on the proportion of its output that it must sell at fixed prices. However, the tax increase on its free market sales will mainly be passed on to final prices and borne by final consumers unless the supply of the good is unresponsive to price changes (or demand is extremely elastic). Similarly, decontrol of a particular price that is seen as raising profitability above average levels will lead to the application of a higher product tax/VAT rate. However, since the higher rate applies to free market sales as well, firms will reduce sales on that market, raising the free market price. The extent of these effects depends once again on the responsiveness of supply and the importance of free market sales in the industry in question. However, with free market sales determining marginal behavior in State-owned enterprises, these effects of tax rate setting are assuming more importance than in the past.  - 36 - Box 2.1: MEASURES OF PROFITABILITY, REINVESTMENT RATES AND THE INTERNAL GROWTH POTENTIAL OF ENTERPRISES There are many criteria by which enterprise performance can be measured. Increases in sales, increases in gross output increases in profits can all be used. None of these mea- sures alone, however, gives a comprehensive measure of enterprise performance. The reasons are easy to see: increases in sales are desirable only if they result in profits; the same is true of higher gross output. Increases in profits need to be related to the investment in capital goods which are used to generate those profits. Return on investment iss therefore often used as a measure of profitability, and the effectiveness with which the firm uses the assets at its disposal to generate income.1/ In relating income earned to total assets managed by enterprise management, one can compare it to alternative uses of the same assets. As such, it is defined as: Net income ROI = Total assets This measures the return obtained on all assets entrusted to the enterprises' management. The concept of profitability most often used in China, and the one chosen by the authorities in the 1983 reform of the tax system as the profitability measure to be equalized, has been a different one, namely return on sales (ROS), that is the income generated on each Rmb of sales. To see how this measure fits into the broader concept of ROI, it is useful to breakdown the ROI into its two component parts: ROI = net income = net income x __sales total assets sales total assets The relationship of net income/sales (ROS) measures the "gross profit margin", or the operating performance of the enterprise. The relationship of sales to total assets in turn measures wasset turnover', or the effectiveness with which assets are used to generate seales. It is quite clear that both profit miargin per unit sold, and sales per Rmb of assets are important.2/ The following example shows why. Box Table Capital Intensive Labor Intensive , E snterprise B (steel) (retail) Sales: 5,000 10,000 Net income: 1,000 100 Total assets: 50,000 1,000 Return on sales: 20% 1% Asset Turnover: 0.5 times 10 times ROI: 10% 10% Enterprise A realizes its income by means of a high profit margin and a low turnover of assets (extensive use of assets). Enterprise B obtains its return by means of a very low profit margin (ROS),, but very intensive use of assets--that is, high asset turnover. A typi- cal 'type BO enterprise would be a retail establishment, which will accept a low profit margin because it has a very high turnover of assets--it has relatively low investments in buildings and inventories turn over quickly. On the other hand, capital intensive industries such as steel, chemicals, etc., which have heavy investment in assets (low asset turnovor rates) will need a high net profit margin in order to obtain the 10% return on assets and the funds neces- sary to reinvest, replenish the capital stock, and most importantly, to grow. Specifically, ROI measures the income generated by assets, before, and independently of, any payments to suppliers of capital, that is, before interest payments or dividend pay- ments. 2/ Frequently, the ROI denominator is adjusted for so-called 'unproductive' investments, or assets, such ars surplus inventories, idle plant or buildings which do not generate income. This would include e.g. housing in most Chinese enterprises.  - 37 - Box 2.1: (cont'd) Asset Turnover l 10% l 10% ROI 1% 10% ROS The chart shows that there is in fact an infinite number of combinations of turnover and ROS, each of which will give rise to a 10X return on all assets deployed. The return on investment is crucial for determining the internal growth potential of an enterprise, since net income is an important source of funds for reinvestment (in addition, of course to bank loans, and/or budgetary grants for enterprises in China). In fact, the standard formula for the internal growth rate of an enterprise 3/ is defined by: g = i income retained * ROI Thus, an enterprise with a 10X ROI, which pays out (in taxes, in dividends, in bonuses or other payouts) 40% of its net income, will grow at a rate of 8%. The important implications for Chinese enterprises of the choice of ROS as a profit- ability measure should by now be clear. By limiting the ROS to the same maximum level (by means of equalizing taxes and other measures) for all enterprises, those enterprises with a high ROS (but low asset turnover) are heavily taxed, and their ROI, and therefore ability to generate funds for growth, is constrained. To take the example of enterprise A: its 20% ROS I would be viewed as 'excessively profitable." Taxes such as the adjustment tax and a high product tax rate are designed to reduce the "profit rate* to a more acceptable level--say to 10%. However, with a 10% ROS, a 0.6% turnover rate and a 40% payout in bonuses and other nonproduction oriented investments, the enterprises' growth will be limited as follows: g = ROI * retention ratio = t10 * 0.6] * 0.e = 3X This was less serious in time when all funds for reinvestment were provided to enterprises by government: the 3% of earnings retained did not truly matter because any shortfalls from the desirable level would be made up by the government. In the post reform period, however, it is a very serious matter. Enterprises which are capital intensive are not permitted the net income to reinvest and grow. To the extent that they borrow from banks to supplement their asset base, they are increasing their leverage (debt/equity ratios). These are not desirable tax-driven effects. The question of using the tax system to equalize profits has been discussed in the text. However, the use of the ROS measure of profitability has serious consequences The difficulty of changing this approach lies in the fact that in China there is no obvious market mechanism for valuing assets. In the absence of asset value, determining the return on assets is clearly difficult. The AMRS version of the contractual responsibility system represents one possible approach to asset valuation. It has in fact been used to value the firm in accordance with the standard 'dividend discount model", by discounting the value of the income stream predicted by the winning bid. This or other mechanisms will need to be further developed, before ROI can be strictly applied. 3/ Rigorously, this holds only in an unleveraged (100% equity financed) enterprise or an enterprise where ROI=ROE. 2.51 The tax authorities indicated that they attempt to take the existence of the free market into account in setting tax rates. However, in practice,  - 38 - unless there are major changes in free market prices, state list prices pro- vide the basis for setting the tax riate, with the choice of a tax rate guided exclusively by a concern for enterprise profEitability. 2.52 CascadirLg. As in many developing countries, China's indlirect tax system derives a significant amount of revenue from indirect taxation on raw materials and capital goods entering the production process. To the extent that enterprises increasingly choose techniques of production, taxes on such goods distort their choices and detract from efficiency in production. By adding to the costs of production, such taxes also increase the cost of exports, adversely affecting China's competitive position. The gradual replacement of Product Tax by VAT is still partial, and allowance is not made in the VAT for taxes paid on all inputs. Hence, the full tax burden borne by a commodity doe!s not consist simply of the tax applied to final output, but also includes taxes paid on inputs, and on inputs used in producing inputs, all the way through the production process. 2.53 The analysis of the effects of cascading is made more complex in China because of the coexistence of VAT and Product Tax. Since en industry subject to VAT can reclaim taxes paid on inputs, a distinction must be drawn between industries subject to VAT and those subject to Product Tax. Also, the amount of taxation that has been borne by inputs into an industry subject to Product Tax will depend on whether those inputs were produced in an industry subject to VAT or in an industry subject to Product Tax. Cascading is also present in industries subject to VAT. While the tax paid on immediate inputs is refunded, this is not the case for taxes paid on inputs into the supplying industry (unless that industry is also subject to VAT). This po.Lnt is of importance in the design of export rebates that typically, as in China, refund taxes paid only on first round inputs, thereby depriving exporters of the full competitive edge which would otherwise prevail. Nonetheless, it must be expected that the effect of cascading is less for goods produced in industries subject to VAT., The extent of cascading is shown in Table 2.1 which demon- strates the considerable differences between the statutory tax rate and the full tax burden. Some basic intermediates such as electricity, coal, coke and heavy chemicals suffer taxation that is double or triple their statutory rates. Cascading of this magnitude also characterizes the sectors statutorily subject to business tax. Sectors subject to VAT suffer less from cascading, although they are affected to some extent. (See Annex 1 for detailed discus- sion of cascading and calculation of cascading effects.) 2.54 To the extent that indirect taxes exhibit significant cascading effects, the system is less efficient than a single-stage sales tax or a value added tax. The calculations lend support to the notion that a VAT covering all sectors would, by eliminating much of the cascading effect of indirect taxes, make the incidence of taxation more closely approach that designed by policymakers in fEormulating the statutory rates of taxation. It would also provide a framework that ensures tax-free access to all inputs, direct and indirect, going into export production.  - 39 - Table 2.1: CHINA - THE EFFECTS OF TAX CASCADING (in %) Effective Average tax rate as X statutory Cascading Effective of statutory Sector Type of tax tax rate effect tax burden rate Agriculture Exempt 0 4 4 - Forestry Exempt 0 1 1 - Animal husbandry Exempt 0 2 2 - Sideline Exempt 0 7 7 - Fishery Exempt 0 7 7 - Metallurgy VAT 14 3 17 120% Electricity Product 6 5 10 200% Coal and coke Product 3 e 9 300% Petroleum Product 30 11 41 137% Heavy chemicals Product 15 11 26 173% Light chemicals VAT 20 4 24 120% Heavy machinery VAT 14 2 18 107% Light machinery VAT 18 3 19 119% Construction materials Product 5 8 13 280% Heavy forestry Product 10 8 18 180% Light forestry VAT 14 3 17 121% Food VAT 16 2 18 112% Textiles VAT 18 2 20 111% Clothing and footwear VAT 14 2 16 114% Paper VAT 14 2 18 114% Other manufacturing VAT 14 3 17 121% Construction Business 3 10 13 433% Transport Business S 7 12 240% Commerce and catering Business 3 8 9 300% Notes: These numbers should be regarded as illustrative for two reasons. First, the input-output table used in the analysis relates to 1981 and is therefore somewhat out of date. Second, the industry definitions are very broad and so group together goods subject to widely different tax rates Cor even type of tax). Therefore, for each industry, it was necessary to decide which type of tax (VAT, Product Tax of Business Tax) applied to most of its output, and what rate of tax could be regarded as representative. Finally, the effects of cascading are underestimated because data did not permit incorporation of taxes paid on capital goods. The methodology underlying the calculation appears in the Appendix to Annex 1. 2.55 The extent to which the indirect tax system in China raises revenue efficiently has yet another dimension. The fact that product and VAT rates in sectors such as cement, crude oil and electricity vary directly with size of the taxed enterprise may be inappropriate. This policy has its genesis in attempts to use these taxes to equalize profitability across large and small producers. To the extent that profitability differentials are related to economies of scale, this approach could have the effect of switching produc- tion to less efficient enterprises.  - 40 - 2.56 Equity. Indirect taxes are not seen as an equity-enhanring instru- ment in China, except in the sense of equalizing profitability across enter- prises.12/ Furthermore, as mentioned before, the equity impact of existing taxes is compl:icated by the fact that taxes set with reference to intersectoral enterprise profitability, when shifted on to prices of free market sales, have different effects on households at different income levels. Data that would permit an analysis cf the effects of taxes on market prices and thus on the distribution of real income among households are not available. However, two observations may be made. First, given the high proportion of food in the actual expenditures of almost all Chinese households, it is the exemption of maost foods from Product Tax/VAT that has the greatest effect on distribution among consumers. Changes in taxes on other goods, that form a small proportion of household budgets, will have little effect. Second, luxury goods have high consumer prices, presumably partly for distributional reasons. This could not have been sustained after the replacement of profit remittance with taxes unless high product tax rates had been used to reduce the profitability of their production. Thus luxury goods are subject to high tax rates in China, as elsewhere. But when fixed consumer prices apply, their impact appears to fall on producers. Business Tax 2.57 Incentives. Levied on gross receipts in all sectors except whole- sale, where it is levied on markup, this tax has the potential for introducing allocative inefficiencies through distortion of input choices. These could be significant for industries such as transport and utilities that taxes are heavily used in interindustry transaLctions. Distortions are also likely in future in financial sector activities.13/ Enterprise Income Tax 2.58 Incentives. In common with other socialist countries, the system of taxation of State enterprises is characterized by a large number of taxes at 12/ There is clearly some interaction between price setting and tax rates (i.e., coordination between the Price Bureau--which sets prices--and the SAT which sets tax rates); the joint tax cum price effect is designed with producer-impacts in mind and full backward shifting is assumed. Indeed, SAT frequently pointed out that tax changes were used instead of price changes to affect profits of enterprises. It is not, however, possible, to verify the extent to which the objective of profit equalization is met, as matching data for industrial profitability and taxes were not: available. 13/ A tax on gross interest receipts raises the cost of lending and will increase intermediation spreads; this widens the wedge between deposit and lending rates. With all domestic institutions presently subject to tax, these effects will occur across all institutions. However, as China's financial sector and financial service sector become more diversified, an important competitive advantage may be conferred on e.g. foreign financial institut:ions and other financial institutions not presently subject to it, whiLle domestic banks are placed at a competitive disadvantage by the tax-induced higher costs.  - 41 - every stage of production and distribution of earnings. The most noticeable characteristic of enterprise taxation in China is the important role of dis- cretion in the interpretation of tax rules. These characteristics are mani- fest in deviations from the 55Z income tax rate, the adjustment tax and various extrabudgetary "clawback" measures to profitable enterprises and, correspondingly, in the extension of subsidies and other preferences to finance wage increases and bonus payments in loss-making units. The impact of these "clawback taxes" on the effective marginal tax rate is shown in Table 2.2. The role of discretion has been heightened with the introduction of the contracting system, which provides a vehicle for extending significant tax preferences to enterprises that are able to bargain successfully with the authorities. 2.59 Customizing tax liabilities through contracting--almost on an enter- prise-by-enterprise basis--is defended on grounds, inter alia, of encouraging efficient use of fixed assets and eliciting some payment to their owner, the State. Tailor-made contracts, the authorities argue, are necessary to adjust for the advantage which accrues to enterprises from free state capital endow- ments, and which varies from enterprise to enterprise. The role of discretion is heightened by the decentralization to provinces permitting provincial dis- cretion in granting of tax preferences. The fact that many of China's social policy objectives, in housing, health care, pensions and education, are met through the activities of the SOEs, coupled with the fact that revenues raised through taxes often have to be shared with higher-level governments, provides a powerful incentive for local governments to provide tax preferences, thereby increasing enterprises' discretionary funds. 2.60 The substitution of rules by discretion, however, has a number of serious disadvantages. First, enterprise-specific variations in tax payments inhibit competition and delay incentives to restructure inefficient enter- prises. Contracting on a case by case basis is therefore inconsistent with the goal of developing a competitive environment for enterprises. Contracts that do not embody uniformity in tax treatment move away from the goal of ultimately directing investment to its most profitable uses. In China, as long as the soft budget (and soft tax) constraint prevail, there will be no pressures from competition or for the allocation of investment to profitable uses such as exist in market economies where the capital market is a force for broad equalization of after-tax returns to equity across enterprises. 2.61 Second, as stated in Chapter I, the inclusion of tax payments in contracts removes an important instrument of macroeconomic management from central government controls.14/ The problem is exacerbated by the fact that such contracts typically run for 3 to 4 years, lengthening the period over which direct tax instruments become unavailable. The existing contracting system, while credible as an attempt to separate ownership and microeconomic management, does not distinguish clearly between the role of the government as owner of assets in SOEs and the role of the government as macroeconomic mana- ger for the economy as a whole. 14/ This is true, a fortiori, for the inclusion of other macroeconomic levers such as interest rates.  - 42 - 2.62 The contractual responsibility system can be expected to introduce a lack of buoyancy into the income tax, as appears to have been the case in 1987. Such an outcome is unsurprising in the short run. However, its recent introduction makes an assessment of its long run consequences premature. In principle, revenue could actually increase if the incentive-enhancing effects of the low marginal tax rate led the enterprise to generate more output and profits. Indeed, the rapid growth of enterprises subject to contracting indi- cates that contracting has positive incentive effects (and also lends weight to the hypothesis advanced earlier, that enterprises respond increasingly to incentives). Data that would allow the incentive effects (and therefore reve- nue impact) of t'he contracting system to be estimated were not available. 2.63 Contracts calling for enterprises to deliver some profit target would in principle result in no diminution in buoyancy of revenue provided the quota were set, not in terms of absolute profit, as is presently often the case, but in terms of anot'her nominal magnitude (e.g., value of sales) which moves with inflation. Even in the extreme caSE! of a zero marginal tax rate, extra reve- nue would be forthcoming from indirect taxes, unless these too were included in the contract, as they sometimes are. Current versions of the contract, however, make the tax base subject to inflationary erosion. This is so, a fortiori, for contracts calling for some absolute level of tax delivery. 2.64 Statutory and Effective Rates of Tax. The statutory rate of tax may be combined with depreciation allowances, interest and principal deductibility and other provisions to calculate how the cash flow from an investment project is affected by applying the rules of the enterprise income tax. The effect is summarized in the "marginal effective tax rate" (METR), estimates of which are presented in Table 2.2. These figures are best treated as illustrative. They also assume that taxes are applied in a uniform manner, as provided in the law, and not as typically happens, i.n China, applied in a discretionary manner by provincial tax administrators. Neither is the existence of contracting reflected in these figures. Contrac:ting wculd be expected to significantly reduce the METR (See Box 1.2). However, the figures do serve to indicate the divergences between statutory and effective rates arising from interactions between taxation, inflation and the mode of' financing of investment projects under these assumptions. The complexities of the institutional setup govern- ing investment in China, together with the pressure from enterprises to invest, imply that the METR is but one determinant of incentives to invest, particularly in State enterprises. With a progressive hardening, of the budget constraint, however, it can be expected to assume greater importance. 2.65 Column (2) shows the METR on a project financed entirely by retained earnings with an inflation rate of 20Z. Large State enterprises face the highest METRs because of their high statutory rate and the extrabudgetary transportation and energy fee. The advantages of debt financing; are shown in column (3) for a project financed 50% by debt (and with allowance for full deductibility of principal payments) and 50Z by retained earnings. The sharp decline in METR for all three types of enterprises is due to twc reasons. First, the deductibility of nominal interest payments overstates true interest payments in the presence of inflation; the decline in the real debt balance implies that a portion of interest payments is actually implicit repayment of principal. Second, the fact that principal repayments are also deductible confers a significant tax advantage as well.  - 43 - Table 2.2: CHINA: MARGINAL EFFECTIVE TAX RATES FOR INVESTMENT IN FIXED ASSETS BY TYPE OF ENTERPRISE IN CHINA /a (In X) 100% SO debt retained financing Statutory earning (principal Enterprise tax rate financing deductible) Large state enterprise 65 87.3/b 48.4 - with extrabudget construction tax 15 (88.0) (48.4) - with wage bonus tax - (96.3) (68.4) Small SOEs & collectives 36 60.3/b 30.1 Individual household enterprise 40 67.7 34.8 Joint venture 33 48.2 26.8 Foreign enterprise s0 70.2 41.4 /a 20% inflation is assumed. b Includes energy and transport tax on extra budgetary funds. Reference: Pellechio, Anthony J., "A Model for Analysis of Taxation of Capital Investment in Developing Countries," Provisional Papers in Public Economics No. 86-28; and Pellechio, Anthony J., Gerardo P. Sicat, and David G. Dunn, "Taxation of Investment in East Asian Countries,* Provisional Papers in Public Economics No. 87-3, Development Research Department, World Bank. 2.66 Equity. Equality between enterprises is a more difficult concept than equality between individuals because there is no natural way to define it. In the 1984 tax reforms it was taken to be profitability on sales and taxes were calculated to yield the same return on sales in each industry. However, this measure of profitability is arbitrary, and, as indicated in Box 2.1, does not account for different enterprises' needs for retained funds. This requirement of greater profitability on sales for more capital-intensive industries would still exist if enterprises relied less on retained earnings or grants, and were free to finance investment by borrowing, since those enterprises with high requirements for retained funds (and subject to high taxes) would become increasingly leveraged, were they to finance expansion by borrowing. Extrabudgetary Construction Tax and Wage Bonus Tax 2.67 The extrabudgetary construction tax was designed as one of the indi- rect fiscal levers used by the state to control investment and, as a tax designed to influence enterprise behavior, is frequently referred to, together with the wage bonus tax as a "behavior tax." Both contribute an insignificant proportion to revenues. The effectiveness of these taxes is difficult to assess empirically. In view of the many factors contributing to investment hunger in China (low interest rates, principal deductibility, enterprise and financial system, liquidity, etc.) it is not surprising for such a tax to perhaps have a limited impact.  - 44 - Resource Tax 2.68 Incentives. The resource tax was mainly adopted to reduce differ- ences in profitability between enterprises arising from free access to natural resources. The fact that it is levied on profits relative to sales means that the production of some exhaustible resources (e.g., coal, oil and gas) are indeed discouraged by it. However, the rates of taxation are not calculated to reflect such exhaustibility. 2.69 Although the resource tax has the beneficial incentive effect of discouraging the production of some exhaustible resources, it is levied in a way that reduces the efficiency wit:h which those resources are extracted. Efficiency in nationwide resource extraction requires that marginal costs of extraction (including transport costs) be equal for all enterprises. The controlled price system implies that more and less efficient enterprises can coexist within the same industry. Since the resource tax is levied at a higher rate on more profitable enterprises without distinguishing between enterprises with varying extraction costs, the tax system can perversely encourage (by taxing them at a lower rate) less profitable, higher cost pro- ducers to expand activity even if their marginal cost is higher than that of more profitable enterprises. 2.70 Finally, the effectiveness of taxes on resource use is reduced in the presence of price controls. In a market economy, a tax on resource extraction will discourage production, raise the market price and therefore discourage consumption of the resource. In contrast, when the price to consumers has been fixed, as in China, consumption is not discouraged. Instead, due to backward shifting of taxes, product:ion will become less profitable, but if the planners decide that production must nevertheless meet demand despite low profitability, the resource will not be conserved. Alternatively, low profit- ability might reduce supply. With fixed consumer prices this would only create excess demand and some form of (possibly informal) rationing. This might conserve the resource, but would not ensure that it was allocated effi- ciently to those who could make the! best use of it. Agriculture Tax 2.71 Incentives. The Agriculture Tax, in theory, should have no incentive effects as it is paid regardless of the volume, or crop composition of output produced. The same is not true of the recently introduced tax on the value of output of nongrain products. The current practice of making the agriculture tax on grain farmers payable by grain farmers in grain valued at low official procurement prices, while other nongrain farmers pay it in cash, creates incentives aga,inst grain production. This practice causes grain farmers to pay an implicit tax arising from the incomne foregone as a result of being denied the opportunity to sell grain in the market at above-procurement prices to meet their tax liability.15/ 2.72 ESI4t. There are two aspects of the distributional effects of the Agriculture Tax, which are straightforward to analyze. First, is the effect 15/ In addition to the agriculture tax, grain farmers pay a second implicit tax in the form of government procurement at a price below the market price.  - 45 - of the tax on the distribution between agriculture and nonagriculture; second, is its effect on distribution within agriculture. Since the early 1950s, Agriculture Tax has fallen as a proportion of total revenue and as a propor- tion of gross output value in agriculture (from 5.9Z in 1952 to 1.1Z in 1986). Thus agriculture has paid less taxes than nonagriculture as a proportion of output, and the extent of the difference has been growing larger. As agricul- tural incomes are generally lower than nonagriculture incomes, this has prob- ably reduced overall income inequality. However, the 'surplus' in the agri- cultural sector has, throughout, been "taxed" by the imposition of low procurement prices and until recently, high delivery quotas. 2.73 As far as inequality within agriculture is concerned, the effect of the tax before the recent introduction of the nongrain tax was probably some- what regressive. It was levied on the basis of "normal grain yields' and thus would be a simple proportional tax if all farmers produced grain. However, the richer farmers typically produce more profitable crops, such as vegeta- bles, and they were not required to pay higher taxes to reflect the suitabil- ity of their land for these more profitable activities. Such regressivity will be offset by the new nongrain tax. However, it continues to be true that grain farmers are subject to the "hidden tax" of agricultural procurement at below market prices.16/ Moreover, regressivity is further offset by the fact that households in severe financial difficulties can be exempted from the tax. Finally, it should be noted that the low rate of explicit tax means that the regressivity is not so serious in its consequences. 2.74 The fact that agricultural households are not liable for Individual Enterprise Income Tax or Personal Income Adjustment Tax does not produce sig- nificant inequity at the moment because most agricultural incomes are lower than nonagricultural incomes. However, if agricultural incomes continue to grow and reach urban income levels, their exemption from these taxes will cause horizontal inequality because Agriculture Tax is so low. Personal Income Adjustment Tax 2.75 Equity. The taxation of personal incomes of citizens is in its infancy in China. While information that would permit an analysis of its impact was not available, it may be conjectured that the combination of global and schedular treatment, taxed at progressive and flat rates respectively, carries the potential for horizontal inequity. The fact that assessment is on individuals rather than households and the lack of allowance for dependents can create anomalies. Finally, it may be noted that the monthly nature of the tax and the prohibition of averaging across months can cause inequitable treatment of individuals (such as writers, performers and others) whose income is concentrated in particular periods of the year. Taxes on External Trade 2.76 Incentives. The effects of customs duties on incentives in interna- tional trade are hard to evaluate because of the lack of discretion allowed to many foreign trade corporations. However, the trend towards greater freedom 16/ See RSAL Background Paper: "Agricultural Land Taxes in the Xinxiang Regional Reform," AS3AG, 1988; for fuller analysis of Agricultural Land Taxes.  - 46 - of action for tr ade corporations and other enterprises that engage in interna- tional trade, maLkes their impact worth considering. Internationally traded goods are subject both to customs duties and Product Tax/VAT. The equality of Product Tax/VAT rates between domestic products and imports accords withth international practice and ensures that these taxes do not discriminate against import.s. Also, the zero-rating of VAT on exports and the development of bonded warehhouses means that the intent of the domestic tax legislation is to avoid discouraging exports. This means that the only incentive effects are through the customs duties themselves, and these are predominantly levied on imports. The import duties are often substantial and apply to a very wide range of goods. The protective effects of these duties are recognized by the authorities, andL indeed constitute a major justification for their existence. 2.77 An evaluation of whether such protection is desirable iis beyond the scope of this report. In general, tariff reform can be considered separately from tax reform because of the small revenue contribution of customs duties. An earlier Bank report indicated that the present tariff structure, with rates ranging from 0-200% results in highly variable "effective protection" of dif- ferent industrial subsectors.l7/ Taxes and Industrial Policy 2.78 Industrial policy involves the promotion of particular industries, as well as particular enterprises. Taxes are a widely used instrument of indus- trial policy. At the level of the individual enterprise this take place through the granting of enterprise income tax, product and customs tax exemp- tions, often to enterprises that are in financial difficulties. In common with other countries, this approach does not always represent a coherent pol- icy based on the evaluation of social costs and benefits, and may be guided by attempts to help a particular interest group. Local governments make signifi- cant use of "industrial policy" to assist 'their" enterprises with the conse- quence that the central government is deprived of an effective t:ax lever. At the sectoral level, the choice of Product Tax and VAT rates often reflects industrial policy aims. For example, the recent switch of the textile indus- try from Product Tax to VAT was accompanied by a reduction in the industry's overall tax burdLen, apparently with the aim of promoting the inclustry. 2.79 The use of taxes to encourage or dLiscourage particular industries can be quite effective in an economy with limited foreign trade. However, as foreign trade expands, the impact at the margin of these taxes c:an be expected to change. Since domestic production will differ from consumption (by the amount of imports) a distinction will have to be drawn between taxes that discourage production and those that discourage consumption. In the case of a commodity such as cigarettes, it is consumption which one would want to dis- courage, and this will only happen if taxes affect prices. Increased taxes with fixed consumer prices will not affect consumption except to the extent that they affect free market sales. Second, taxes in an economyt with trade will affect domestic producers as well as Lmporters, and a tax r-eduction that 17/ Report No. 6680-CHA: External 'Trade and Capital. IBRD, 1987.  - 47 - stimulates production will also stimulate imports. For both reasons, direct subsidies are preferred.18/ C. Recommendations 2.80 Recommendations for tax reform focus on three major taxes in the present system--the system of indirect (product-cum-VAT) taxes; the enterprise income tax and to a lesser extent, the resource tax. This choice of emphasis lies in the fact that between them, these taxes contribute 85% of tax revenues, and that therefore the bulk of any revenue impact would come from modification of these taxes. Secondly, their allocative impact, as analyzed in Section B, is also significant, so that major benefits could be derived from modification of their design or application. Finally, reforming the system of taxation of enterprises and the rationalization of indirect taxes is essential for enterprise and price reforms to be deepened. This analysis hitherto has emphasized the desirability of viewing taxes and price controls as part of an integrated system. This implies that recommendations on the reform of taxation, especially indirect taxation, must be sensitive to assump- tions made regarding the pace of price reform. 2.81 The recommendations also seek to build on the strengths of the exist- ing tax system in China, focusing on refinements and modifications to the major taxes now in place (such as the VAT, contracting and other aspects of the enterprise income tax) instead of recommending radical change or a wholly new structure. In brief, the recommendations take as given the configuration of the tax system and seek to eliminate some of its weak issues. 2.82 Recommendations with regard to the remaining taxes, such as those on the agricultural sector and customs taxes (together contributing some 7-8% of revenues) are briefly summarized in paras. 2.140-2.150. These recommendations reflect the analysis of previous World Bank mission reports which have under- taken in-depth analysis of these sectors. The Report's recommendations are summarized in a matrix at the end of the chapter (Table 2.7). Indirect Taxes 2.83 Characteristics of the Recommended VAT. The mission recommends that the existing value added tax cum-product tax be replaced by a value added tax of the consumption type, implemented via the invoice method, that (a) applies to manufacturing and imports, (b) exempts agriculture and services and (c) "zero-rates" exports. Such a system would have the following characteristics. The tax liability of an enterprise under the VAT would be reduced by taxes already paid on raw materials as well as capital goods. Such a VAT, which includes tax payments on capital goods as well as on raw materials, is said to be of the consumption type. The enterprise under an "invoice method VAT" would be "credited" for taxes paid on inputs and would therefore send the authorities the difference between the tax liability on outputs and that 18/ Producer subsidies have the advantages that they do not distort consumption choices and, as they involve a more obvious budgetary cost than variable tax rates tax reductions, they require more careful justification and are therefore more likely to be used wisely.  - 48 - already paid on intermediate inputs. This is a VAT utilizing the invoice method in its implementation.l9/ The base Eor taxation would be the domestic or foreign value added of goods sold to final consumers in China. This would tax imports and exempt exports. Such a VAT is said to embody the destination principle and is permissible under GATT rules. 2.84 It is also recommended that tax rates be expressed as a proportion of producer, rather than purchaser prices. That is, rates should be set on a so- called "tax-exclusive" basis. 2.85 As noted in Section B, the system of indirect taxation currently ruling in China has many, though not all, of these characteristics. The authorities are aware of the production inef-ficiencies caused by the cascading of turnover taxes in the manufacturing sector (Table 2.1 indicated that there are significant differences between the statutory rate of tax applying to a sector and its full tax burden), and the gradual replacement of product tax by VAT is intended to alleviate this problem. Second, the taxation of imports and zero-rating of exports to the extent current circumstances permit implies that the VAT in China embodies the destination principle. 2.86 In not allowing credits for tax paiLd on fixed assets, thLe Chinese VAT discriminates against investment and deviates from prevailing practice in most countries.20/ In China, the need to control. what is widely perceived to be "overinvestment" could make this seern an advantage in the present macroeco- nomic circumstances. Nevertheless it is preferable to deal with potential macroeconomic imbalances using monetary, interest rate and other macroeconomic tools, and by tightening the tax treatment of loan repayments (see para. 2.135 for discussion on this topic). This would ensure that existing distortions are addressed at source rather than by introducing other distortions into the indirect tax system. The changeover to a consumption-type VAT can be expected to encounter some transitional problems. These include the appropriate tax treatment of fixed assets that have already paid taxes before the changeover was introduced. Considerable experience is available regarding the methods used by various countries to efect a transition from a turnover to a consumption-type VAT.211 2.87 The existing value added tax in China further deviates from best practice in developing and industrial countries by not employing the invoice method in its iimplementation and presumptively crediting inputs. Under the 19/ The administrative advantages of the invoice method as distinct from other methodis of calculating tax liability are discussed in Annex 3. 20, VAT systems which disallow credit for taxes paid on capital goods--the so-called "income-type" VATs--are generally not used. Exceptions among LDCs are Argentina and Peru and, to some extent, Turkey. Such taxes do, however, credit taxes paid on capital goods when the latter depreciate. 21/ For more details of VAT and international experience on transition to VAT, see Ta:it, Alan A.; Value Added Tax International Experience and Problems. (Ref) 1987. See also Annex 1.  - 49 - invoice method, the tax already paid by an enterprise on its purchase invoices is subtracted from the tax due on its outputs and the difference is forwarded to the tax authorities. The invoice method has a "self-policing" characteris- tic since any incentive on the buyer's part to overstate the tax paid on the transaction is offset by the opposite incentive (to understate tax paid) on the seller's part. Selective checking of invoices--to ensure they are identi- cal--on the part of the tax administration is, however, usually still neces- sary to promote tax compliance. This will require strengthening of the audit function of the Tax Bureaux.22/ 2.88 The VAT recommended in this report would apply equally to imports and to domestic production. Where the VAT is applied, current practice in China is consistent with this recommendation. Treating imports and domestic produc- tion alike ensures that customs duties and quantitative restrictions on imports play an unambiguously protective role and can be set in accordance with the requirements of industrial policy. The fact that customs duties account for only 9Z of revenue implies that rate adjustments could be done without significantly adverse revenue consequences. 2.89 The VAT recommended by the report is of the manufacturing-cum-import type, and would therefore have the same scope as the current Product Tax and VAT. This has two implications. First, it would not extend through the wholesale and retail stages and would not therefore replace the Business Tax. The VAT extends through the retail stage in the countries of the European Community, in Hungary, in Latin America as well in Madagascar, Niger, Korea, Taiwan and Israel. The reason a retail VAT is not recommended for China at the present time is the administrative difficulty of bringing a very large number of retailers into the tax net. At the same time, the administration of the Business Tax should be tightened and consideration eventually given to a second stage of reform where the VAT would replace the Business Tax as well and extend through the retail level. 2.90 Second, the tax would not include sectors such as agriculture, ser- vices and financial institutions. The reason is again purely administrative. Registering a large number of agricultural units would be an extremely burden- some task in China. Agriculture would therefore be exempted (not zero rated). The exemption of agriculture implies that while agricultural sales themselves would not be subject to VAT, inputs used or imported by the agricultural sec- tor would have paid taxes which could not be credited. 2.91 Exports would be zero-rated--i.e., exempted from taxes on outputs as well as inputs. Zero-rating implies that an exporting enterprise would qual- ify for refunds from the government unless it has tax liability on its domes- tic sales greater than the tax credit earned on exports. In many developing countries refunds from government departments in practice have proved time- consuming and it is accordingly recommended in China that refunds, when due, be made speedily. 2.92 Replacing the Product Tax with the VAT has two advantages: First, by removing the divergences (estimated in Section B) between statutory tax rates 22/ See Chapter IV for discussion of administering VAT.  - 50 - and the actual tax borne by each sector, it makes the effects of taxation clearer to the tax setting authorities. Second, it makes certain that export- ers enjoy the full benefits of "zero rating", i.e., being refunded taxes not only on the direct inputs entering export production, but taxes on inputs entering into the production of those inputs. This increases the competitive- ness of Chinese! exports in world markets, whlile being consistent with GATT rules. Indeed, the methods used to calculate the extent of cascading in Sec- tion B, if applied to disaggregated idata on exports, could be used to calcu- late the export subsidies required to compensate exporters for the effects of cascading under the present tax systiem. 2.93 The VAT of the kind recommended for China could be implemented even in the absence of price reform. Implementation would, however, be made easier with a more simplified rate structure. The adoption of such a raLte structure depends, inter alia, on price reform. This is due to the use of the product tax/VAT to affect profitability of sectors producing goods subject to price control. International practice reflects a more limited range of rates than is found in China. The VAT used by most countries either has a zero rate or an exemption applying to necessities, a standard rate for the majority of sectors,and a higher rate applicable to luxury items and those goods whose consumption the authorities wish to discouraLge. Table 2.3 provides some exam- ples. It shows the main rates of VAT and additional rates for limited catego- ries of goods in the EEC countries (which have the longest experience of using VAT), other European countries, selected Latin American countries, and in New Zealand, Taiwan, Indonesia, and Korea. The rates shown are those that apply to domestic sales; virtually all of the countries zero-rate exports. The largest number of different rates is seven (in Belgium), but two or three rates are more cojmmon. In Asia, Indonesia has a single rate while Korea and Taiwan, China, which began with single rates, now have three rates. Table 2.3: THE RATE STRUCTURE OF VAT IN SELECTED COUNTRIES Main rate Other VAT rates /a Number of rates Argentina 18 9 2 Austria 20 10, 32 3 Belgium 19 1, 6, 17, 26, 33, 0 7 Denmark 22 0 2 France 18.8 2.1, 4.5, 6.7, 33.3 6 Germany 14 7, 2 3 Greece 18 3, 6, 36 4 Hungary 26 15 2 Indonesia 10 1 Ireland 26 2.2, 10, 0 4 Israel 15 6.8 2 Italy 18 2, 9, 38, 0 S Korea 10 2, 3.5 3 Luxembourg 12 3, 6 3 Netherlands 20 6, 0 3 New Zealand 10 - 1 Norway 20 11.11 2 Portugal 16 8, 30, 0 4 Spain 12 8, 33 3 Sweden 23.46 3.96, 12.87, 0 4 Taiwan, China 6 15, 25 3 United Kingdom 15 0 2 /a Some countries having multiple VAT rates apply these rates to only one or two commodities, with the bulk of the VAT base taxed at a single rate. Source: Value Added Tax: International Practice and Problems, A. A. Tait, Table 2-1, p. 40.  - 51 - 2.94 The imposition of supplementary excises on luxury goods and perhaps others is consistent with international practice, and poses no administrative difficulties. Most countries have additional taxes on particular commodities. These are separate from the VAT and are therefore not subject to refund. In the European Community these additional taxes are mainly in the form of excise taxes on tobacco, alcohol, gasoline and diesel oil. The rates vary widely from one country to another, but are often higher than the VAT levied on the goods in question. In Indonesia, the additional taxes are levied at either 1OZ or 20Z on goods that are regarded as luxuries. In Korea, there is a Spe- cial Excise Tax that is levied at rates between 5Z and 100Z on selected goods. 2.95 International opinion is divided as to the appropriate tax treatment of luxuries and other goods whose consumption the government wishes to dis- courage. One option is to incorporate luxury rates into the VAT, with supple- mentary excises on special items. A second option is a single rate VAT, coupled with supplementary excise taxes outside the VAT. Since luxury rates would, in most cases, apply to final rather than intermediate goods, a supple- mentary excise does not raise issues of crediting which would normally create a preference in favor of the VAT. Another advantage of using supplementary excises is that they simplify the VAT administration. A supplementary excise at a rate higher than the standard rate of VAT on petroleum products, which have substantial intermediate uses, with the excess not being creditable under the VAT, is justified as follows. Because of the difficulty of charging directly for road use, it is desirable to tax inputs going directly into the road transport sector, and petroleum products are therefore a suitable tax base. To the extent that such taxes distort the use of petroleum by nonroad users, the level of taxation needs careful consideration. The experience of other countries can be used to develop guidelines in this area. 2.96 However, whatever method is chosen, supplementary rates should apply at the same rate to both domestic production and imports. Lack of such symme- try (i.e., taxing imports only) would have the unintended consequence of pro- viding protection to domestic production of goods subject to such excises, such as tobacco, alcohol and petroleum products in China. Implications of Recommended VAT Changes 2.97 The tax authorities have maintained that adopting a single rate VAT and supplementary excises is constrained by the existence of price controls. This point of view, and the extent to which price controls militate against adopting a VAT structure that accords with international practice can be understood by examining what effects the elimination of price controls would have on enterprise profitability. Enterprise profitability will be affected by eliminating price controls on both inputs and outputs. The following dis- cussion analyzes these in turn. Because the tax proposals mainly relate to nonagricultural goods, the discussion is confined to the effects of eliminat- ing price controls on nonagricultural goods. 2.98 Impact of Retail Price Liberalization on Profitability. The simplest assumption regarding the effects of eliminating retail price controls is that retail prices will rise to the current level of free market prices. It could be argued that free market prices might be reduced somewhat by the general reduction in households' real incomes, following withdrawal of the subsidy  - 52 - implicit in controlled prices, although this in turn could be offset by expli- cit subsidies to households. The simple assumption is adopted here. The impact of removing price controls depiends therefore on the free matrket prices of comnodities and on the proportion of sales that take place at controlled and free prices. 2.99 The analysis of the subsidy implicit in price controls (para. 2.43) may be adapted to show that price decontrol of final goods would raise retail prices of daily use and other goods by 5.6% and 18% respectively. With retail sales of "daily use' and "other" goods of Y 43.5 and Y 154.2 billion respec- tively, these price increases would yield income transfers to ente!rprises of Y 2.4 and Y 27.7 billion respectively, for a potential gain in prcifits of Y 30.1 billion, or 9Z of total industrial value added. With a 152 VAT 23/ and an enterprise tax payable on this increment, enterprises would gain, after taxes, Y 12.5 billion in after-tax profits, to be distributed among investment and workers' remuneration funds according to existing guidelines. The govern- ment's revenue gain from VAT levied al: 15% on Y 30 billion would be Y 4.5 billion, wqhile the revenue from profits tax levied at 49Z on Y 25.6 billion would equal Rmb 12.5 billion, for a total gain of Y 17 billion, or close to 20Z of total Product Tax and VAT revenue.24/ The higher profitability will not accrue to all industries equally, and ranges Erom a low of 162 increase in profits as a % of value added for industries producing "daily use" goods, to a high of 38% for industries producing "other goods." D100 These changes in sectoral profitability in relation to value added could in principle be offset by suitable changes in the rates of VAT. How- ever, this will typically require a d:ifferentiated structure of VAT rates. This illustrates an important point. The impact of price reform on sectoral profitability depends on the proportion of sales transacted at controlled prices, as well as the differential between controlled prices and free market prices. The profitability-offsetting moves in VAT rates then depend on the ratios of controll-ed sales to value added. Thus, while the existing product tax/VAT may have been set with reference to sales profitability considera- tions, the removal of price controls alone will not eliminate the sectoral profitability differentials just described, and will not permit complete sim- plification of the VAT rate structure on final goods. A uniform VAT on final goods must be accompanied by a charge or dividend on assets with which enter- prises have been endowed by the State and by enharLced capital mobility in response to intersectoral profit differentials, if the remaining profit dif- ferentials are to be reduced or eliminated. 2.101 Impact on Profitability of Decontrolling Intermediate Goods Prices. Turning to the e:Efects of relaxing price controls on intermediates, it has already been observed that eliminating price controls on inputs would cause their prices to rise to the current level of market levels. Under assumptions 231 This is the VAT rate (calculated in para. 2.107) which would approximate the revenue from product tax. 24/ Data refer to 1L986. Additional revenue would be forthcoming from the extrabudgetary energy and transportation fee and the wage incriease and bonus taxes. i(The detailed sectoral impact on profitability is calculated in Annex 1).  - 53 - of profit maximization 25/ and in light of the evidence that the dual pricing system has encouraged marginal enterprise decisions to be made on the basis of uncontrolled market prices,261 the increase in input prices to free market levels will not affect the marginal cost of enterprises purchasing inputs on the free market. An increase in a controlled price to the higher, free market level, will be akin to the removal of a lump sum subsidy. In that case, relaxing price controls would have an effect on enterprise profits but no effect on consumer prices.27/ The effect of decontrolling intermediate goods prices is the reallocation of profits between supplier enterprises and pur- chasing enterprises. Some illustrative calculations using the 1981 input- output table are presented in Table 2.4. (More up-to-date data--not made available to the mission--could be used to get more accurate results.) 2.102 With liberalization of intermediate good prices then, it is assumed that all intermediate goods are sold at market prices, and that only sales to consumers are subject to price controls. Column 1 of Table 2.4 shows consumer sales in relation to value added (for each sector of the 1981 input/output table.) If VAT is shifted forward at every stage of production on all sales that take place at market prices, its negative impact on enterprise profita- bility (as a proportion of value added) will depend on the share of controlled price final sales, where forward shifting will not be possible.28/ Assuming that only sales to final consumers are subject to controls, and that these controls cover 50Z,29/ the second column of Table 2.4 may be regarded as the effect on profitability of a 1002 VAT. 25/ Evidence from enterprise studies suggests that managers "are driven by a desire to increase benefits to enterprise employees... The main avenue for purusit of these ultimate objectives was increased profits". (quotation from Perkins, op. cit.) The increase in the 1980s in the proportion of profits that enterprises are allowed to retain for their own use is seen as having contributed to such an orientation on the part of managers. 26/ cf. Perkins op. cit. 27/ If enterprises have objectives other than profit-maximization, the removal of the lump sum subsidy implicit in price controls on intermediate goods could lead to some increase in final goods prices. 28/ The assumption on shifting, in common with much applied work on tax incidence, postulates that the tax is fully forward shifted at every stage of production on that portion of sales that takes place at market prices. The full forward shifting assumption is justified (a) either if there are constant returns to scale and fixed factor prices; or (b) more plausibly, as a central case with imperfect market structures. See Stern, N. "Aspects of the General Theory of Tax Reform" in Newbery, D. and N. Stern (eds.) The Theory of Taxation for Developing Countries (Oxford University Press for the World Bank, 1987). 29/ The mission was informed by the Price Bureau that 47Z of consumer goods were sold at State list prices in 1986.  - 54 - Table 2.4: EFFECTS OF VALUE ADDED TAX CHANGES ON SECTORAL PROFITABILITY Sales to Final Consumers Impact of 100% VAT on as % of value added /a enterprise profitability /b Metallurgy 1% 0.5% Electricity 9% 4.6% Coal and Coke 26% 13% Petroleum 6% 2.5X Heavy Chemicals 2% 1% Light Chemicals 92% 48% Heavy Machinery 8% 4% Light Machinery 137% 68.5% Construction Mats 4% 2% Heavy Forestry 33% 16.6% Light Forestry 94% 47% Food 248% 124% Textiles 74% 37% Clothing 180% 90% Paper 39% 19.5% Other Manufactures 66% 33% La Value of sales to consumers as a percentage of valuB added in 1981. Lb The effect of 100% VAT on Industry profitability is expressed as a percentage of value added, on the assumption that 50% of sales to consumers are at state list prices. (blumerically, this is 100% x (sales to final consumers) x 0.5.) Figures are shown only for those sectors where VAT is levied or is likely to be levied. It does not include the full range cf (24) sectors in the I-0 table. 2.103 Many industries (such as metallurgy, heavy chemicals and construction materials) sell relatively small amounts to final consumers in re:Lation to their value added., Therefore, only a small proportion of their sales would remain price controlled after intermediate good price liberalization, and a large change in their profitability is therefore likely to occur. To offset this increase in profitability would require impossibly large changes in VAT rates. (Even the 100Z VAT shown in the table does not affect these sectors' profitability greatly). Thus, the changes in VAT on intermediate goods required for unification or simplification of the VAT--which would be far smaller than 100Z-.-would have a very limited impact on profitability of many intermediate goods producing industries. The report therefore recommends that the VAT be simplified towards a common rate for most intermediates. It may be noted that while the assumption of intermediate goods price decontrol under- lies the particulaLr numbers shown in Table 2.4, the conclusion that VAT is a relatively weak tool for affecting the profitability of intermedate goods sectors holds more generally. Therefore, the recommendation that the VAT be simplified on intermediates would not be affected. Unifying the VAT FRate 2.104 The preceding discussion shows that the VAT is a more potent instru- ment for affecting profitability in consumer goods than in intermediate goods industries. Simplification towards a common rate for most intermediates is therefore recommended. Unification (as district from simplification) is not possible at this stage, and would need to await price reform and aLppropriate pricing of fixed assets, with a view ito broad equalization of after-tax rates of return on those assets. Thus, full reforma of the VAT would proceed in two  - 55 - stages. While all other recommendations on the VAT should be currently imple- mentable, the adoption of a single-rate VAT has been shown in the preceding discussion to depend on the pace of other reforms in the economy, specific- ally, price reform. The implications of a fully unified VAT are discussed below. 2.105 Implications of the Recommended Unified VAT Rate: Revenue. The "revenue adequacy" of a single rate VAT depends on whether such a VAT system could raise as much or more revenue as the product and other taxes it replaces. If one assumes that the change in tax rates has no effect on the output or value added in any industry, the calculation of the required VAT rate involves determining the revenue requirement or target, and the tax base: the rate is then obtained by dividing the revenue target by the tax base.30/ 2.106 The unified VAT would have to raise some Y 66 billion (the revenues in 1986 from VAT and product tax, excluding those on liquor, tobacco and petroleum products) to replace revenues from the current VAT and product tax. The tax base from which this revenue will be collected under VAT consists of (a) industrial value added (excluding tobacco, alcohol and petroleum prod- ucts); (b) imports; and (c) industrial purchases of agricultural products, since the latter are tax-exempt and cannot be deducted from enterprises' VAT liability. In 1986, these were Y 302 billion; Y 150 billion; and Y 37 billion respectively, making the VAT base (disregarding export refunds) approximately Y 489 billion. The tax rate needed to raise Y 66 billion is thus roughly 13.5Z. Assuming that VAT on manufactured exports will be effectively rebated, and removing exports from the tax base reduces the tax base to Y 397 billion and the necessary tax rate rises to 16.6Z. 2.107 These two estimates represent the upper and lower bounds on plausible VAT rates and it is not unreasonable to take an intermediate figure of 15Z as representing the "best guess'. This is broadly consistent with the current approach used by the SAT in setting VAT rates: 14Z is taken as a standard rate that is used most often. Upward deviations from this figure are very fre- quent, and this is consistent with the fact that 14% is very near the lower end of the range calculated above. 2.108 A uniform rate of VAT at 15Z will need to be supplemented by excise taxes in the case of some industries, to capture the required revenues. Uni- fying the VAT on tobacco to a 15Z VAT would raise only Y 2.1 billion, in con- trast to the Y 11.3 billion currently collected from the product tax on tobacco products. A supplementary excise tax would therefore have to raise Y 9.2 billion. The base of such an excise tax would be total output value of the industry of Y 17.2 billion. To generate Y 9.2 billion, the excise tax 30/ Full calculations of the revenue impact of this recommendation are given in Annex 1. This "zero-elasticity" assumption is almost certainly inaccurate, but no data are available to estimate likely changes in output and value added. It is impossible to say a priori whether the use of this assumption results in the overestimation or underestimation of the required tax rate.  - 56 - rate on tobacco products would be 53%. For petroleum products, the excise tax would have to be 16Z.31/ 2.109 Implications of a Unified VAT Rate: Profitability. The effect of a uniform VAT rate on enterprise profitability (defined as return on sales) may also be illustrated. If the product tax on rubber products, to take an exam- ple, (which averages between 10 to 20X) were converted to a VAT in such a way that tax revenue (Y 1.6 billion on gross sales value of Y 15.4 billion) is preserved, the rate would have to be 32Z, much higher than the unified VAT of 15Z. (Y 1.6 bilLion on a 1986 value added of Y 5.05 billion). With the assumed, unified 15Z rate, if all output is subject to price controls, enter- prise profits will increase by the full extent of the VAT rate reduction, i.e. by 17% of the industry's value added, (32Z-15Z) or by Y 0.859 billion. Retained profit:s will increase (using the current 55% rate of enterprise tax) by Y 0.386 billion, equivalent--for the sake of perspective--to 21Z of the wage bill. 2.110 The effect of this tax rate reduction on profitability will differ if the industry is not subject to price controls. In that case, the increase in profitability wi]Ll encourage enterprises to expand output and, if the industry is profit maximizing and there is no shortage of supply, prices will fall until the level of profitability is the same as before. To estimate the extent of the pr:Lce decline, note that at a VAT rate of 32X the enterprise receives Y 68 for every Rmb 100 of sales. At a VAT rate of 15Z, after-tax sales revenue of Y 68 may be obtained at a sales price of 6810.85 = Y 80 per unit. Therefore1, competition among enterprises could lead to a 20% fall in free market prices. Total industry profits will rise if output rises in response to the increased demand generated by lower prices, but profits per unit of sales woould continue to be the same. 2.111 If, in :Line with the average situation for intermediate goods, 60% of rubber goes for plan sales and 40% at guidance and market prices, the reduced VAT rate will :increase the profitability of plan sales while for free market sales, output wi:Ll rise, prices will fall, and profits per unit lof sale remain unchanged. Ultimately, the profit increase is 60% of profits ac]hieved when all sales take p:Lace at fixed prices, (Y 0.386 billion) or Y 0.231 billion. 2.112 The same analysis can be applied to an industry whose taxation would increase followinlg unification of VAT. The reduction in profitability will again depend on the proportion of output that is sold at fixed and free prices. In general, the effects of VAT unification on profitability will be smallest for industries that sell high proportions of output at free market prices, and largest for those selling their output at controlled prices. 31/ Value added in tobacco products is Y 14 billion so that a 15% VAT would yield Y 2.:L billion. This example is only an illustration of the principles involved as it neglects untaxed inputs into tobacco manufacturing and assumes that all tobacco products are taxed at the same rate. The data required for a more detailed analysis of tobacco products were not available. See Annex 1 for full details of tobacco and petroleurm products excise taxation.  - 57 - 2.113 Implications of a Unified VAT: Revenue Growth. Replacing existing indirect taxes by a single rate VAT and supplementary excises can be made revenue-neutral by suitable choice of rate, and, furthermore, that rate is close to that used in presumptive crediting under the existing VAT. While this is reassuring, it is essential that any tax changes proposed also ensure revenue growth from indirect taxes in line with GDP. This is a highly desir- able feature of a tax system, since it does not require frequent changes in tax rates to ensure revenue growth. Such rate changes, as pointed out in Chapter 1, when introduced for purely budgetary reasons, typically pay insuf- ficient attention to issues of efficiency and resource allocation, in addition to the uncertainty they introduce in decision-making for households and enter- prises. Looking to the future, when Chinese enterprises will be more respon- sive to price signals, such ad hoc tax changes will have inefficient outcomes. It is therefore essential that modifications to China's tax system be under- taken with buoyancy in mind. 2.114 Theoretical arguments suggest that the VAT is an elastic tax. The VAT reform proposed in this report would move taxes away from the productive sector in China and towards households. This is the essence of consumption taxation. Since consumption is the single largest component of national income in China, as elsewhere, such a move ensures that tax revenues will move at least in line with gross domestic product. Revenue growth is further enhanced by the low rates of tax applied to necessities, whose consumption grows relatively slowly as income grows, and by higher rates applied to luxur- ies whose consumption grows relatively rapidly. 2.115 Empirically, the VAT has been a elastic tax, as Table 2.5 shows. Cross-country evidence as reported in that table shows that many countries have experienced an increase in revenue from VAT plus other taxes on goods and services as a proportion of GDP from 1975 to 1985. Exceptions are provided by Belgium, Denmark and Korea in the later part of the period and Italy in the earlier. Although this reflects a combination of changes in tax rates as well as the responsiveness of revenue from a fixed tax structure, the evidence suggests that countries contemplating the introduction of a VAT could in gen- eral expect to maintain growth of indirect tax in revenue at least in line with that in GDP. 2.116 The countries identified in the table have a VAT that extends through the retail level. This implies that the tax is levied on final consumers and is, therefore, a tax on final consumption. This is not true of the manufacturing-cum-import stage VAT recommended in this report, for China, which would not subject the wholesale and retail trades to VAT. Therefore, strictly speaking, the tax is not levied on final consumption. Nevertheless, inasmuch as the recommendations move the point of taxation closer to consump- tion, with the possibility of going through the retail level at a subsequent stage of reform, the evidence presented in the table is relevant in judging the buoyancy of tax revenues under the proposed VAT. 2.117 Introducing a Simplified VAT: Concluding Remarks. In summary, while simplification of VAT rates, particularly for intermediate goods, is feasible and is recommended under current circumstances, the implementation of a fully unified VAT must await price and enterprise reform. In the absence of such reforms, a VAT of the type recommended in the report would continue to be  - 58 - Table 2.5: GROWTH OF VAT REVENUE IN SELECTED COUNTRIES (DOMESTIC TAX ON G&S AS X OF GDP) First Year of VAT 1975 1980 1986 Argentina 1976 3.5 5.9 7.8 Austria 1973 8.5 8.8 9.4 Belgium 1971 9.8 10.8 9.6 Denmark 1967 13.7 16.7 16.3 France 1968 11.7 12.2 12.3 Germany 1968 8.5 6.8 6.7 Ireland 1972 9.4 10.9 13.6 * Italy 1973 8.2 7.7 8.2 Luxembourg 1970 8.0 8.4 10.4 * Netherlands 1969 9.5 10.4 10.3 Norway 1970 16.3 18.2 17.4 Sweden 1969 9.3 10.3 11.9 United Kingdom 1973 8.4 9.8 11.6 Israel 1978 - 12.8 16.0 Korea 1977 8.2 7.9 * Figures for 1985 were not available so 1984 figures are reported. Source: Government Finance Statistics; IMF, Washington, DC. borne in part by the enterprise sector. With such reforms, the tax burden on enterprises would be eliminated because (a) inputs bought by enterprises would be credited; and (b) taxes on output would be shifted forward to the wholesale and retail trades and agriculture and, ult.imately, rural and urban households. Taxation of Enterprises 2.118 Taxation and Contracting. Although revenue from the erLterprise income tax is second only to indirect taxes, its growth has not recently kept pace with that of profit growth. As noted in Section B, it may be conjectured that this was mainly due to the increasing use of the contractual responsibil- ity system in state enterprises, especially the Contract Management Responsi- bility System (CMRS), which, of all the for-ms of contracting, by contracting for tax delivery, most directly subverts the system of substituting profit taxation for profit remittances. 2.119 Enterprise reform is of critical importance in the process of overall reform in China. Hitherto, it has been gu.Lded by two important considera- tions. First, to provide incentives to enterprises to make efficient use of the fixed assets with which they have been costlessly endowed. And, second, to reduce the role of discretion in dealings between enterprises; and their supervising bureaus in favor of rules. The goals of direct tax reform are overlapping, although not identical. They are first, to provide a stable source of revenue to the government; and second, to offer incentives to enter- prises to expand output and profits. 2.120 The substitution of profit remittances by profit taxation constituted both enterprise reform and tax reform. The first was reflected in the trans- fer to enterprises of profits and choice of dispositions of profits; the second by the introduction of a government role qua formal fiscaLl entity. This underlines the close links between the two. Although the shift from remittance to retention caused a decline in budgetary receipts, the rapid  - 59 - growth of enterprises where it was experimentally introduced indicate that it had very positive incentive effects. 2.121 In contrast, some of the tax aspects of the contractual responsibil- ity system in its most widely used variant, the CMRS, by subverting the sub- stitution of taxation for profit remittance, contributes little to tax reform. In promoting discretion rather than rules, the CMRS has the potential for reducing enterprises' responsibility for their own decisions, thereby compro- mising the effectiveness of tax instruments as levers of economic policy. And, by allowing tax liabilities to be contracted virtually on an enterprise- by-enterprise basis, the symbiotic relationship between supervisory agencies and State enterprises is strengthened. Finally, the use of a quota that is either constant or grows at a rate less than that of the industrial sector, together with a marginal rate of tax that is significantly below the basic rate, could impair the growth of revenue. 2.122 Not all these concerns are present in equal degree in all types of contract. For example of the four major types, the AMRS is generally not associated with tax remission; leasing contracts likewise call for full tax payment. Moreover, the AMRS includes components that help value the net worth of State enterprises. Such valuation techniques are essential if asset mar- kets or the introduction of dividends based on enterprise net worth are to develop. However, to date the ARMS is less widely applied than the CMRS and other approaches more associated with tax remission, so that, overall, tax reform has not been supported by contracting. 2.123 Some perspective on the tension between the enterprise income tax and the contractual responsibility system is provided by observing that, since 1978, the authorities have alternated between these systems. Profit remit- tances were replaced by profit taxation in 1983, following experiments initia- ted in 1978 adjudged a considerable success. 1981-82, however, witnessed the emergence of the Quota Responsibility system. To the extent that this system allowed--in the first steps of the tax reform--a substantial element of dis- cretion and was vulnerable to ratchet effects, there was a move away from the quota responsibility system towards profit taxation, so that virtually all profit-making State enterprises came to be on the profit tax system by 1983/84. The contractual responsibility system, however, made a strong reap- pearance in 1986/87 and it was decided late in 1987 to implement the CMRS variant more widely. The alternation between these two systems, together with the types of contracts now in use, suggest a continuing tension between com- peting models of enterprise reform and are part of the background against which different tax proposals will be assessed. 2.124 Taxation Versus Ownership. The importance of the distinction between the State as tax collector and the State as owner of fixed assets in State enterprises is by now well recognized. The recommendations in this section of the Report urge that profit taxation be used as the instrument of the tax collector, while the contractual responsibility system serve the needs of the asset or resource owner. The following recommendations address that distinc- tion. First, the Report recommends that the taxation of State enterprises occur via the system of profit taxation without exception and that all enter- prises be subject to the basic rate of income tax. The basic rate of enter- prise tax should be maintained concurrently with and pending the reform of the  - 60 - contracting system. As a transitional matter, it may be undesirable to alter contracts under which enterprises have assurances or have committed to profit transfers, prior to their expiration. Until the contracting is reformed, new contracts should. follow the criteriia outlined above with respect to exclusion of taxes in ccntracts and the maintenance of a basic 55% tax rate. Most con- tracts should have run their course by 1990 or 1991, so that by this time it would be expected that all enterprises wou:Ld be paying the standard base rate of tax. 2.125 The Enterprise Tax Rate. Consideration is being given in China to lowering the basic rate of enterprise incorne tax from its current level of 55Z in order to provide greater incentives to enterprises and to bring the rate in line with the generally lower corporate income taxes in other countries. The mission recommends that decreases in tax rates not be implemented until the tax preferences prevalent under the contractual responsibility system have been fully eliminated. 2.126 Two reasons argue against ia reduction of the basic rate in the absence of other measures. 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 theme, which was illustrated in the marginal effective tax rate calculations of Section B, argues for simultaneous consid- eration of all provisions of the enterprise income tax and not simply its statutory rate. Second, decreases in tax rates, unaccompanied by revenue- raising measures, should not be implemented until the tax preferences preva- lent under the contractual responsibility system and other reverLue-eroding aspects of the enterprise income tax, such as principal deductibility, can be phased out. To do otherwise would be to risk losing significant amounts of revenue at a time when fiscal policy must play an important part. in overall macroeconomic management. Moreover, until the expenditure implications of reforms in social security, housing and other areas and their financing struc- ture are known., reducing the tax rate is not recommended. Reassessing the tax rate only after the full budgetary impact of such reforms is known will pre- clude the possible need to make major upward revisions as each reform pro- ceeds. 2.127 Maintenance of the basic rate of enterprise income tax at its current 55Z level pending reform of the contractual responsibility system implies that it will not be possible to unify the tax treatment of State enterprises with collectives and individual household enterprises. While this unification may be a desirable longer-term goal, it is the report's view that taking control of the revenue base through the taxation of State enterprises should receive higher priority than unification of tax treatment across different organiza- tional forms. Abolition of tax preferences in the contractual responsibility system would offer the opportunity to implement a unified rate of enterprise income taxation. That rate would be set by the authorities with reference to revenue requirements. Lack of information prec:Ludes the report from making a recommendation on what that rate might eventual:Ly be. 2.128 The report also recommends that new contracts under the contractual responsibility system henceforth not be used to permit any exemptions from indirect taxes or customs duties.  - 61 - 2.129 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 the tax base. 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. 2.130 With the maintenance of a basic enterprise income tax rate at 55Z, the retained profits of the enterprises will still include surplus which owes itself to their endowment of capital from the State, received, in the past, costlessly through budgetary grants. It is the disposition of this after tax surplus as between the State and the enterprise which should be subject to negotiation. Determination of the appropriate payment to the State is a com- plex matter, since compensating the State by way of a dividend for the contri- bution its assets make to enterprise earnings requires the assets themselves to be valued, a process which must await price reform. With attempts to broaden bidding in the contractual responsibility system (as is now done with the AMRS), it can be expected that such contractual charges in the presence of capital market reform would begin to approach market-related valuations for enterprises. 2.131 Further developments in this direction will also allow for modifica- tion of the adjustment tax. The present adjustment tax on State enterprises is seen as a way of equalizing profits across enterprises within a sector, in part, to tax those profits enterprises earn attributable to their state capi- tal. In some sense, it can be construed as a charge use of fixed capital. With the further attempts to refine bidding into contracting out of after-tax profits as recommended by the Report, together with capital market reform, market-related valuations for enterprises can be expected to emerge. At some time following these developments, it would be appropriate to phase out the adjustment tax altogether. 2.132 These recommendations are consistent with the substitution of rules for discretion emphasized in Section B, that is central to enterprise reform. At the same time, they respond to the important tradeoff between revenue and efficiency. The government's revenue base would be more adequately protected, and the advantages of the contractual responsibility system as a management device could be preserved and, where necessary, improved, but without preju- dice to the interests of the tax collector. 2.133 These proposals attempt to retain the more attractive features of the enterprise income tax and the contractual responsibility system. While exper- imentation with different variants of the latter system has yielded valuable insights into its generic strengths and weaknesses, it is suggested that con- sideration be given to narrowing its range to a few 'standard" after tax archetypes that would apply to all enterprises. Failure to do so would impede the development of competitive forces to which enterprises must ultimately be subject in the interests of enterprise reform and efficiency. 2.134 The Enterprise Income Tax. The enterprise income tax in China dif- fers from international practice in one major respect, namely in the deducti- bility of amortization of bank loans from taxable profits. This is in addi- tion to the deductibility of interest, a practice found in the corporate  - 62 - income tax of many countries. The tax-deductibility of principal and interest in China embodies part of the provisions of the comprehensive cash flow tax (described in Annex 1)321 but without including loan proceeds in the tax base as income. While the replacement of budgetary grants with bank loans has been consistent with enterprise reform, this generous treatment of amortization and interest is anomalous in general, and particularly so at a time 'When over- investment by enterprises is considered to be a serious problem. 2.135 The Report recommends that the amortization of bank loans be disal- lowed effective now, with borrowing for new investment as a deduction from taxable income. This would have a positive effect on government revenue and, by raising the cost of capital, exert a dampening effect on investment, while bringing enterpr:ise taxation somewhat closer to international practice on the income tax. A broad estimate of its implications are outlined below. 2.136 Disallowing Principal: Implications for Revenue and Profitability. Most loans in China are amortized over five to ten years.33/ With loan financing of investment approaching 15% in state enterprises, the impact of including amortization in taxable income could be significant. Table 2.6 below presents an estimate of the possible impact on revenue and profitabil- ity, assuming all amortization were immediately taxable. These calculations can therefore be viewed as a "steady state" revenue and profit equilibrium. If, instead, amortization were disallowed on new loans only, the profit and revenue impact would be much less in the initial year--amounting to a 3-4Z revenue impact,, and an impact on profits of a slightly smaller magnitude. Additional revenues would be raised in the second year, and the full impact on revenue and profitability would be felt only at the end of the amortization period. Inclusion of amortization (calculated at Y 14.2 billion) in the tax base, therefore, leads to substantially higher taxable income of Y 148.3 bil- lion which, taxed at the average prevailing effective rate of 49Z, potentially increases government revenues by some 11Z. The new treatment would lead ulti- mately to a differential of 1OZ in the after tax profits of statie enterprises compared to what they would have been under the present system and a corres- ponding decline 'in their profitability, whether defined vis-a-viis fixed assets or sales. 2.137 These calculations embody a number of upward biases. First, disal- lowing amortization is likely to lead to a reduction in borrowing, so that the fixed base assumption used in the calculation overestimates both the revenue gain and the resulting decline in enterprise profitability. Second, since under the contract system, a number of enterprises in more recent periods are paying income tax at a statutory rate well below 55Z (and an effective rate less than 49Z), the revenue gain (and decline in profitability) fErom disallow- ing amortization payments is also over estimated. To the extent that the 32/ Zodrow, George R., and McLure, Charles IE., "Alternative Methods of Taxing Consumption in Developing Countries," World Bank, Country Economics Department, January 1988. 331 The formal amortization schedule calls for equal repayment over a 5-year period; however, the Finance Department at the provincial level and below (or the relevant industrial bureau) may authorize repayment over a longer period, up to 10 years.  - 63 - proportion of investment financed by loans has increased, these effects are underestimates. Nevertheless, even with downward adjustments in those calcu- lations, it would appear that implementation of the recommendation to disallow amortization payments as an expense against the enterprise income tax would cause a significant change in income tax revenue and enterprise profitability. The report therefore recommends it be applied to all new borrowing for invest- ment. The removal of tax deductibility of amortization would make it easier to introduce a consumption VAT without stimulating excessive investment. Table 2.6: ELIMINATING PRINCIPAL DEDUCTIBILITY: REVENUE AND PROFITABILITY EFFECTS (Y billion) Present system After change in tax treatment Taxable profit 134.1 134.1 + 14.2 = 148.3 Taxes: la -66.2 Taxes: = -72.0 After tax profit = 68.9 After tax profit = 76.2 LESS Amortization -14.2 Net enterprise retentions = 68.9 Net enterprise retentions = 62.0 Revenue increase is: 72.0 - 65.1 = 11% 65.1 Decline in retentions = 88.9 - 62.0 = 10% 88.9 La Using a rate of 49%. Eight-year amortization assumed. This is the average effective tax rate, calculated as enterprise tax paid (Y 65.1 billion) divided by total profits (Y 134.1 billion). The tax figures include income and adjustment taxes. Tax rate is calculated as Y 65.15 + Y 134.14 = 49%. Note that for this purpose, working capital loans are treated as "interest only' loans; there is no amortization. Cumulative amortization since 1981 has been calculated as Y 14.2 billion. For full details, see Annex 1. 2.138 The Report did not have the information necessary to quantify the extent to which the policy change recommended here, by raising the cost of borrowing, would restrain investment in enterprises. If state enterprises continue to be subject to a soft budget constraint, the worsening of their profitability position would lead to demands for subsidies that would eventu- ally offset both the revenue gains and the altered profitability of State enterprises, hence nullifying the effect of the policy change. As mentioned before, available evidence from enterprise studies suggests that the reforms have led to some hardening of the budget constraint.34/ Furthermore, loss making enterprises do not constitute the majority of Chinese industries. For these reasons, the measure can be expected to have an impact on State enter- prises. It will have a mixed impact on enterprises outside the State sector. On the one hand, 40Z of their loan repayments are even at present paid out of after-tax incomes; on the other, such enterprises are not characterized by as soft a budget constraint. 34/ Tidrick and Chen; China's Industrial Reforms. Oxford University Press, for IBRD, 1987.  - 64 - Resource Tax 2.139 The report recommends that the tax authorities charge fior 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 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 the 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. 2.140 Efficiency in resource allocation ideally requires that enterprises be charged a price that reflects the social value per unit of resources extracted by them. Risks of exploration and development, where significant, should be efficiently shared between the State and enterprises engaged in resource extraction. This is to be seen not as a tax but as a cost per unit of resource use. The payment would represent a return to the State qua resource owner. The cost to the enterprise, being a payment to a factor of production, would normally be deductible from the enterprise income tax. However, the social value of a resource is often difficult to arrive at, given the lack of information about the volume andi quality of natural resource deposits prior tco exploration. Different countries have resortecd to different arrangements in. order to get a return on resources they own. 2.141 Many, such as Bolivia (bismuth, siLver, uranium), Chile (copper, uranium), Colombia (uranium, emeralds, platinum), Gabon (uranium), Jamaica (bauxite), Malaysia (iron ore), and lMexico (gold, silver, iron, coal), Nigeria (oil), Zaire (copper, oil), employ either a specific or ad valorem royalty on production or sales. Others, notably Papua New Guinea (copper) aLnd Indonesia, levy excess profits tax, with the latter cotntry charging ad valorem royalty as well. 2.142 In addition to the above, governments of some countries have equity participations in resource exploration. For example, State-owned enterprises are responsible for exploration in Zambia and Zaire (with the exception of petroleum). Another mechanism, that is used mainly in the US, is the auction- ing of resource exploitation rights in return for a lump sum payment to the government. It is necessary to emphasize that the appropriate combination of instruments for securing payments for resources depends on the nature of the resource in question and importantly on the risks involved in exploration and development. 2.143 The mission did not study in detail the resource sector in China and is therefore not in a position to recommend how the types of arrangements outlined above could be adapted to its particular circumstances. But the following general point may be made. It is important to maintain the distinc- tion between the State as tax collector and the State as owner, in this case, of natural resources. It is therefore recommended that enterprises engaged in resource extraction be subject to the income tax at the same basic rate apply- ing to all State enterprises. In adclition resource fees and royalties would  - 65 - in general be charged, and would accrue to the state as owner of the resource. (Such royalties would be allowable deductions against the enterprise income tax). Any sharing arrangements deemed appropriate for the State as owner of the enterprise's fixed assets, would apply to after-tax profits only. Thus, the State would receive: (a) taxes due under the enterprise income tax; (b) a payment for ownership of the fixed assets of the enterprise; as well as (c) a payment/royalty on the natural resources which it owns and which the enter- prise is engaged in extracting. 2.144 The royalties, or charges for resource extraction, could be estimated in a number of ways. The AMRS variant of the contractual responsibility sys- tem, that values enterprise assets as the discounted value of the stream of profits forecast by the winning bidder, could be used as a model for valuing resource rights to enterprises extracting natural resources. That value, however generated, could be used to assign either a charge per unit of resource extracted or to design lump sum charges or profit-related sharing arrangements of the kind observed in other countries and described earlier. In the absence of such information, an excess profits tax or royalty could be applied, set at a "presumptive' rate based on the experiences of other coun- tries. It is suggested that the details of such resource taxation be studied carefully in China.351 2.145 The Report recommends that the State, which presently levies the resource tax only on coal, oil and gas, charge also for mineral resources. The tax should not, however, vary as it does at present, by size of enter- prise. 2.146 Urban Land Tax. Finally, the same arguments establish the desirabil- ity of charging for land, in the absence of a rental market. Current propos- als envisage such charges for land converted from agricultural use. It is important that the land use fee or tax be set at a level that reflects land's social value. A recent Bank study outlined these issues in greater detail.36/ The Land Tax--to be applied in urban areas--in order to compensate the government as owner of land is in keeping with both of the fundamentals of reform; which are (a) to increase the claim of government as owner of the resource; and (b) to require enterprises endowed with resources from which they derive rents, to be charged accordingly. The tax as it presently stands is (i) too low to have an effect on land use decisions; (ii) does not ade- quately reflect the value of the government's claim on the land resource; and (iii) has been set too low to provide the government with adequate revenues. The Bank study recommended that the land tax rates be raised, and that the land tax base be assessed to the extent possible, by more accurately valuing the land and its location value. As land markets develop, observed land 35/ Conrad, Robert F., "Mining Taxation: A Numerical Introduction," National Tax Journal, December 1980, pp. 443-449. Conrad, Robert F., 'A Framework for Analysis of Mineral Tax Policy in Sub-Saharan Africa,' World Bank, Country Economics Department, August 1988. 361 Land Use Taxation in China; Roy Bahl and Zhang Jun; INURD Working Paper; May 1988.  - 66 - exchange prices could be used. If the base is indexed, the land tax could become a robust source of local government revenues. 2.147 Taxation of enterprise profits, together with a contracting on after- tax profits in thes 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 rescurces--(in the absence of markets for such inputs) more truly reflects their social value and that incentives to improve efficiency in use are correspondingly enhanced. In the a'bsence of such prices for enterprise inputs, greater retention of earnings 'by enter- prises is no guarantee of better resource allocation. Other Taxes 2.148 Trade 'axes. The distortions and highly differentiated effective protection arising from China's current customs regime led an earlier Bank report 37/ to recommend that tariff rates should be made more uniform. Based on the trade situation in 1986, the report recommended that tariff rates be confined to within a 10-50% range and that the widespread duty exemptions for imported machinery and capital goods that result in a penalty for domestic producers should also be eliminated. The present mission did not have occa- sion to focus oIn the trade sector, and to extend or modify these conclusions. 2.149 Personal Income Taxation. Although this tax currently plays a very modest role in the tax system, it has the potential of being progressive in incidence and, hence, of attenuating the pre-tax inequalities in income that accompany liberal:ization. Such developments must however await improvements in tax administration. The experiments underway in Beijing and Shanghai on strengthening the withholding system are a useful step. The mission was informed that the proportion of revenue from the PIAT raised through self- compliance increased from 15% in 1987 to 22Z in the first quarter of 1988. While this is encouraging, consideration should be given to furthier improving incentives for se]Lf-compliance. The report also recommends making the PIAT an annual, not monthly, tax, and proposes that, to the extent feasibLe from an administrative poJint of view, the tax be applied on global income, and on income in kind, especially cash and near-cash subsidies. 2.150 Business Tax. The report recommends that the Business Tax continue to be applied to all service sectors, pending the extension of the VAT through to the retail level. 2.151 Agriculture Tax. China has undertaken a number of experiments in the taxation of agriculture notably under the regional development programs (RDP) in areas selected for reforms.381 Two features of the reforms are noteworthy. The first is a significant increase in the tax rate itself, in some cases a doubling. This is; intended to increase revenues to the government, while its burden to peasants will be more than offset by their sales of procluce at mar- ket prices. A second is the payment of the agricultural tax in grain valued 37/ Report No. 6680-CHA, External Trade and Capital. IBRD, 1987. 38/ These were described in "Agricultural Land Taxes in the XinxiaLng Regional Reform" RSAL Working Paper.  - 67 - at market prices; or alternatively, the payment by grain farmers in cash. This is intended to eliminate the bias against grain producers, who are liable for tax in grain, valued at below-market prices, and thus subject to an addi- tional "hidden tax", equal to the opportunity cost of foregone market sales of their produce. Putting an end to this hidden tax would restore some of the profitability of grain production vis-a-vis specialty crops, an important consideration for China at present. An earlier Bank report recommended that consideration be given to widening these reforms. The present mission did not have occasion to focus on agriculture taxation and to modify or extend these conclusions. 2.152 Agriculture Land Transformation Tax. China is also concerned about the loss of productive farmland to urban uses, and a new one-time tax on the conversion of such land is intended to discourage such conversion. While the mission did not have the opportunity to study this in detail, further moves to extend such a tax more broadly call for further study of land use more gener- ally, especially in and around urban areas. 2.153 Extrabudgetary Funds, Extrabudgetary Construction, and Wage Bonus. Taxes such as those on extrabudgetary funds and extrabudgetary construction are frequently used in socialist countries. Their purpose is to discourage excessive growth of investment and encourage more rational use of capital by implicitly 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 rates and credit policy--have become effective and when the price of capital itself is sufficient to regulate investment decisions. The wage bonus tax should be phased out as wages reform proceeds and replaced with the personal income tax whose reach extends to the level of a larger number of urban income earners. The Reform Package and its Revenue Implications 2.154 This chapter has argued that maintenance of revenue from product tax and VAT could be achieved by a single rate VAT in the neighborhood of 15Z,39/ if price reform were to be undertaken as well. In the absence of price reform, it was shown that simplification in the VAT rate structure for intermediate goods was desirable. If more revenue were needed in order to reestablish macroeconomic control prior to price reform, the authorities could resort to a temporary across-the-board levy in indirect taxes on top of the VAT without disturbing the exempt status of agriculture and the zero rating of exports. Cross country evidence was used to argue that VAT-cum-luxury excises would be a buoyant source of revenue. 2.155 With respect to indirect tax revenue, the effect of tax-cum-price reform can be summarized as follows: Decontrolling intermediate goods prices will reallocate profits between intermediate goods producing enterprises and final goods enterprises, both of which are in principle taxed at the same rate. The decontrol of retail prices would however transfer income from final consumers and increase profits of enterprises producing those goods. It was estimated that the additional profits from retail price decontrol could 39/ Data on demand responses that would permit refining this estimate were not available.  - 68 - approach Y 30.1 billion, which would be subjiect to both VAT and enterprise tax. 2,156 The revenrue accruing from the increiases in enterprise profitability was estimated to approach Y 17 billion, or 20Z of total product tax and VAT revenue,40/ 41/ The revenue deriving in the steady state calculation from eliminating princi.pal deductibility was estimated to be some Y 6.8 billion, or 112 of total enterprise tax revenues (and 3Z of total revenues). Phased in on new investment on]y, the revenue could be some 'Y 2 billion in the first year, or about 3% of enterprise tax revenues (and 1.3Z of total revenues). The Phasing of Tax Reform: A Summary 2.157 The Report has recommended reforms in three broad areas, including enterprise taxes and contracting, the VAT and resource taxes, with lesser focus on the personal income tax, agriculture tax and custom dutieas. Clearly, not all recommendations can be implemented immediately, and this chapter has sought to indicate which of the reforms can 'be undertaken even in the absence of reforms in other areas must be coordinated with progress in reEorms in the areas. 2158 Taking VAT as an example, in the absence of price reform, unification of the VAT rate structure is prevented because of the continuing need to use indirect taxes to equalize sectoral profitability differentials arising from price distortions. It follows that initiating price reform would imply greater scope for using VAT and that tax and initiating 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 that :is similar to other countries.42/ Such a VAT would have the advantage of minimrizing distortions of the market prices, while fulfilling the major tasks of revenue-raising, protecting t'he living standards of the poor and discouraginig socially undesirable consumption. 40/ Depending on t:he applicable contracting tax rate, the revenue yield was estimated inI t:he text to be: (a) from t'he VAT: Y 30.1 billion x (.15) = Y 4.5 bil]Lion; plus (b) Y 25.66 billion x (.49) = Y 12.5 billion or Y 17.0 billiLon total. 41/ It is worth being reminded of the "fixed base" nature of thesea calculations. Data on household expenditures and demand pattierns would allow better estimates to be made. Likewise, these estimates are based on a one-time decontrol of all prices, and assume that 49Z eniterprise income tax is applied to incremental profits. It must also bes emphasized that these are first round, or impact effects. 42! Indirect taxes could no longer be seen as falling entirely on the producer or on profits, but would be borne mainly by consumers, except for products where supply is unresponsive or inelastic to price changes. Therefore, differential taxes would not be able to carry out one of their main current aims: the equalization of profitability between industries. Indeed, in those industries where competition is reasonably strong, the relaxation of price controls would remove one of the major causes of unequal profitability.  - 69 - 2.159 Similar coordination is called for with the natural resource tax. A reduction in price control will remove some distortions but not those differ- ences in profitability due to differential access to natural resources. Indeed, more widespread use of the price mechanism makes it more important that enterprises should face the entire costs of their activities, including their use of natural resources. The resource tax or similar resource charges should therefore be extended as price reform proceeds, to cover the major natural resources. It is, however, difficult to reform fully in the absence of any price reform. 2.160 The matrix in Table 2.7 summarizes the phasing of tax reforms recom- mended in this report. Even in the absence of further changes in enterprise or price reforms, the Report recommends, (i) introducing VAT through the manufacturer-cum-importer stage at a more limited range of rates (say 3-5) than now applies on intermediate goods; (ii) selective excises to supplement VAT; and (iii) fully eliminating any remissions of indirect taxes in new con- tracts. In the longer run, VAT could be applied at a single, uniform rate and the Report recommends unifying VAT rates on final goods as price reforms pro- ceed. 2.161 With respect to direct taxes, the report recommends (i) eliminating contracting on pretax profits in any new contracts being negotiated, and main- taining the present 55X enterprise tax rate on taxable income; (ii) phasing in the elimination of deductibility of loan principal beginning with borrowilng for new loans, and (iii) building on the strength of the contracting system by contracting for a dividend to be paid to the state as owner of fixed assets. In the longer term, the enterprise income tax may be unified across types of enterprise and steps could be taken to reduce the rate of this tax, if consis- tent with future revenue needs. 2.162 In the near term, resource extracting enterprises should (i) be made subject to the enterprise income tax, (ii) royalties or fees for each resource type should be applied to encourage more effective production of resources, and (iii) as for other enterprises, contracting should be permitted only on the enterprises' after-tax profits, to compensate the state as owner of the enterprise assets (as distinct from owner of the natural resource). Over the longer term, royalties and extraction rights would be set by competitive bid- ding and the tax extended to all resources. 2.163 With regard to other taxes such as the PIT, the annualization of the personal income tax payments and strengthening of administrative arrangements for wage withholding could be initiated immediately. In the longer run, the wage bonus tax could also be phased out as personal income taxation based on withholding gains ground. Finally taxes such as those on extra budgetary funds, and construction, could be phased out as macroeconomic tools are made more effective. 2.164 The Report cited the recommendations of an earlier Bank report that agriculture tax reforms--well underway as experiments in certain areas--be extended. These included (i) increasing the tax rate, and (ii) allowing grain and other producers able to meet a cash tax liability. In the longer run, the value of agricultural land should be reassessed by localities.  - 70 - 2.165 With respect to trade taxes, the Report also cited the conclusion of an earlier Bank report to eliminate exemptions on customs duties in contracts; and (ii) eliminate exemptions on capital goods imports. In the longer term, that report also recommended reducing the range of import duty raLtes.  - 71 - Table 2.7: SUMMARY OF RECOMMENDATIONS Recommendation Near Term Steps Medium Term I. Indirect Taxes 1. VAT - Introduce VAT through manufac- - Extend VAT to retail level at turer/importer stage at a more uniform rate following price limited range of rates prior reform to pifce reform. - UHify VAT rate for intermedi- ates - No remission or contracting of indirect taxes in new con- tracts - Maintain supplementary excises 2. Business Tax - Strengthen administration of - Replace with VAT in some ser- business tax vice sectors II. Direct Taxes 1. Enterprise - Eliminate tax remission in new - Reduce rate to below 56%, if income tax contracts and contracting this is consistent with reve- forms (CMRs) which contract nue objective for pre-tax profits - Maintain present 65% rate pending reform of contracting - Introduce contracting on after - Develop into dividend policy tax profits only -Begin to eliminate deductibil- - Full elimination of principal ity of principal on new repayment deductibility: investment follows automatically 2. Personal Income - Annualize personal income tax - Introduce broadly and phase Tax and base on household income out wage bonus tax -Strenthen wage withholding aspects of PIT III. Resource Tax - Eliminate tax remission in new - Extend to mineral resources contracts and contracting forms (CMRs) which contract for pre-tax profits for source-extracting enterprises - Maintain present 65% rate pending reform of contract system - Introduce royalties/fees on - Introduce valuation of presumptive basis resource rights - Contract on after-tax profits only - Consider extension of the Resource Tax to land IV. Customs 1. Import Duties - Reduce number of tariff rates - Narrow duty range (as recom- as recommended in Trade Report mended in Trade Report) - No exemption of customs duties in contracts V. Agricultural Taxes - Reassess tax rate and other recommendations as per RSAL Report VI. Other Taxes Extrabudgetary Funds - - Eliminate as and when macro- Tax economic levers (interest rates) are strengthened Extrabudgetary Con- struction Tax Wage Bonus Tax - Phase out and replace with personal income tax  - 72 - III. CENTRAL-LOCAL FISCAL RELATIONS AND REVENUE SHARIN4G Introduction 321 The tax structure and the system of intergovernmental fiscal rela- tions are inextricably linked in the Chinese fiscal system. The laws of taxa- tion and the powers and responsibilities of the various levels of government are laid down by the central government, and subnational governments are responsible for tax administration, share in revenue collections, and have a substantial amourLt of latitude in awarding tax preferences to enterprises. The development of the system--perhaps better characterized as a series of arrangements--of tax administration and central/local relations has given provincial and local governments increasing freedom to alter the fiscal system to meet their own objectives. Among the more important implications of this arrangement is that the "tax levers" the central government designs may be different from th,e fiscal measures actually implemented at the local level. Yet the success cf any central government tax reform will depend on the imple- mentation by su.bnational governments.l/ A successful tax reform program in China will almcost certainly have to be accornpanied by changes in the system of intergovernmental relations. Section A below reviews the experience, princi- ples and criteria for decentralized and centralized fiscal systems. In Sec- tion B, China's system of intergovernmental relations is described. An ini- tial assessment is outlined in Section C, while Section D develops options for reform. One option is in keeping with the present centralized model, but strengthens it irL numerous ways; another is a decentralized model. The choice between these two depends on the Chinlese authorities' desire for macro-control and equalizaticin capability, compared with the benefits of decentralization. A. Fiscal Decentralization and the Role of Local Government: Principles, Criteria and the International Practice 3.2 In China and in virtually every other country there is clebate about the "proper" way to organize the public sector to deliver and finance ser- vices. Most of the debate centers around which level of government should provide which public services, how much fiscal autonomy should the local gov- ernment have, and the relationship between the revenue base given to local governments and their expenditure responsibilities. This section is meant to develop a framework for thinking about such questions in China. Fiscal Centralization vs Fiscal Decentralization 3.3 The arguments for fiscal centralization and decentralization relate to the major tax objectives of government--stabilization policy, equity between units of government and resource allocation and growth. Where the flexibility to pursue stabilization policy is especially important (such as in 1/ In China, and in this report, all Provinces and Cities with provincial status are referred to as provincial governments (including the cities which have Province status; Shanghai, Beijing and Tianjin), w7hile cities and counties are referred to as "local" governments. Where both levels of government are referred to, the report indicates "subnational1. "  - 73 - low income economies "exposed" to international fluctuations, variations in commodity prices, etc.) central government control of the major tax and bor- rowing instruments would be called for. It is sometimes thought that the implementation of economic growth policy also argues for fiscal centraliza- tion. Where investment capital is short, its mobilization and direction by the central government can help maximize returns.2/ If local governments are given access to major tax bases, they may "compete" with the central govern- ment and therefore limit the amount that is available for the central govern- ment. On the expenditure side, more centralization allows the government to steer the allocation of public resources in the direction of goods and ser- vices with national benefits, whereas more local autonomy would inevitably produce more localized benefits. 3.4 Income distribution arguments also support the case for fiscal cen- tralization. In most developing countries, regional, and/or rural-urban dis- parities in income and wealth are pronounced, and may be accentuated by fiscal decentralization because the already wealthier urban local governments will benefit most from increased local government taxing powers. A centralized fiscal system will enable the central government to provide transfers to poorer provinces. Finally, central governments are thought to have a superior capacity in the areas of tax administration. A corollary to this argument is that skilled fiscal managers--analysts, accountants, valuers, collectors--are in too short supply in LDCs to be shared between the central and local govern- ments. 3.5 There are also good theoretical arguments for a decentralized struc- ture of local governance in LDCs. Perhaps the most compelling is that local governments because of their proximity, are able to reach the growing taxable capacity in urban areas more easily than could the central government. An increased rate of national resource mobilization could occur. It is very difficult for central governments to capture much of this fiscal surplus. Neither central government income nor consumption taxes typically reach small firms, workers in smaller firms or outside the larger cities, or the self- employed. Local government business and occupation licenses, sales taxes, permits and property taxes have a much better chance. What Revenue Raising Powers For Subnational Governments? 3.6 Theory does not provide a guide to the "right" share of national revenues and expenditures for local governments. Beyond the obvious conclu- sion that revenue responsibility and expenditure assignment should be in bal- ance, little guidance can be offered as to the optimal division of revenues among central and subnational governments. Neither may China look to some international norm for guidance in deciding on which revenue sources should be allocated to Provincial and local governments. One valid generalization which can be made is that the proper mix of subnational government revenues depends in part on the expenditure responsibilities which are assigned to subnational governments. In fact, for a given set of expenditure responsibilities, an appropriate revenue mix may be chosen largely on efficiency grounds. 2/ Note that this does not argue for a larger role of government per se, but only for a larger share of the center, vis-a-vis local governments.  .. 74 - 3.7 For publicly provided goods and services, where the benefits accrue to individuals within a jurisdiction and where the exclusion principle can be applied in pricing, user charges are most efficient.3/ This is the case particularly for public utilities such as water supply, sewerage, power, and telephone, but also for public transit and housing. Other local services, such as general local administration, traffic control, street lighting and security, are local public goods whose primary benefits accrue to the local population but where the exclusion principle in pricing cannot be applied. These are most appropriately financed by taxes whose burden is local. 3.8 Provincial or national intergovernmental transfers should contribute to financing services such as health and education where substantial spill- overs into neighboring jurisdictions occur. Purely local financing tends to underprovide these services from a regional or national perspective. Finally, borrowing is an appropriate source of financing capital outlays for infra- structure with long-lasting benefits. This is the case particularly for pub- lic utility and road infrastructure expenditure. Expenditures cf an infra- structural nature, or others with broader provincial or national benefit are appropriately financed at the provincial or national level. 3.9 The assignment of taxes to national and subnational governments varies widely. Taxes usually levied at the national level include resource taxes, and personal and corporate income taxes because of their important role in stabilization and distribution policy. Customs duties are also almost always national-level taxes because of their strategic importance. Sales taxes are often levied at the provincial level. Excises and surcharges are also often provincial taxes, as their revernue growth is stable. 3.10 There are many exceptions to these patterns: Switzerland and the United States permit local jurisdictions to levy corporate income taxes as well as personal income taxes and natural resource taxes. By contrast, in Australia and Canada the provinces are prevented from using sales or other indirect taxes. In Nigeria, until recently, export duties accrued to local governments, and, in Malaysia, natural resource taxes are local. The actual practice of revenue assignment may be explained by a variety of factors, both historical and political, and by the relative tax capacities of specific levels of government (and the differing availability of tax bases at the local level). The relative administrative strength of the national and subnational governments is also important in determining the outcome, as is the division of expenditure responsibilities between them, itself usually related to the capacities of national and local-level governments. Intergovernmental Transfers 3.11 Whatever the outcome of the tax assignment, it often leaves one level of government with insufficient revenues. Many countries have resolved the revenue/expenditure imbalance between central and lower level governments and the division of taxing authority with a system of central governrment trans- fers--shared taxes, various types oiE grants and even loans--to subnational 3/ See Roy Bahl and Johannes Linn; Urban Finance in Developing Countries; forthcoming.  - 75 - governments. This permits central governments to retain the authority to levy taxes on the more productive bases, but it gives provincial or local govern- ments a flow of revenues. This is a step toward fiscal decentralization in that it provides financing for subnational government services, but the degree to which it gives subnational governments more autonomy in their budget deci- sions depends on how the system is structured. 3.12 The design of a program of intergovernmental transfers should be led by the objectives the government wants to achieve. But which level of govern- ment should define the objectives? Because objectives such as equity, revenue elasticity and neutrality often conflict, establishing priorities is diffi- cult. These questions raise an important but frequently misunderstood feature of intergovernmental transfer systems: even with the best of design, any system has advantages and disadvantages. On the one hand, a formal (formula) program of intergovernmental transfers can broaden the resource base of local governments and provide for a growing source of revenue if transfers are rela- ted to the growth in a more elastic central government tax base (e.g., if transfers are a share of sales or income taxes). A transfer program has the added advantage of avoiding the high administrative costs which can be asso- ciated with local government tax assessment and collection. On the other hand, transfers and shared taxes can make subnational governments less accountable for their fiscal decisions (they may now increase spending without increasing taxes); hence, there will be less incentive to improve the effi- ciency of subnational government operations. Likewise, when transfers are large, subnational governments will have less incentive to search for new revenue sources or to improve the efficiency of collection from existing bases, and their tax effort may be dampened. 3.13 Other "advantages" and "disadvantages" are much less clear-cut. For example, an important issue in the design of transfer systems is the choice of whether and how the transfers will be controlled by the center. A disadvant- age of central control, from the point of view of the subnational governments, is that transfer allocations may be political decisions and the flow of funds will be uncertain in amount from year to year. This makes fiscal planning very difficult for local governments. On the other hand, central control can enhance the budget flexibility of the central government, and in that sense is a great advantage for the center's macroeconomic management. Another example is that in some countries transfers carry "matching requirements", meaning that local governments must match a portion of the central transfer. This can distort subnational government expenditure choices if they are encouraged to spend because of the low "tax price" of certain types of outlay. Viewed from the central government's point of view, however, such conditions attached to the receipt of such transfers may help accomplish national goals. 3.14 In fact, transfer policies are always controversial from some point of view. Indeed, conclusions about the advantages and disadvantages of any particular program of central transfers to subnational governments depends on whether a national or a subnational government point of view is taken. Uncertainty for one level of government about the regularity and adequacy of transfer flows is the other level of government's budgetary flexibility. 3.15 Depending on their priorities, governments make use of many different types of transfer grants. Shared taxes, distributed on a basis of origin of  - 76 - collections, are an effective way to support the public finances in urban areas and to stimulate their tax compliance. "Formula grants" are typically used to distribute funds according to a formula based on expenditure needs and fiscal capacity. There are usually two objectives of transfer policy: (a) correcting "vertical imbalances," that is the misalignment of expenditure responsibility and tax capacity among levels of government; and (b) reducing geographical or "horizontal" differences between rich and poor provinces to permit a more equal level of expenditures among regions. 3.16 In order to pursue horizont:al equity, shared taxes are not always allocated to local governments in the same proportion as they are collected. Instead, revenue sharing may allocalte shared taxes on the basis of population, urbanization, per capita incomes, etc. Grants allocated on a basis of per capita income or another index of need may also be used to offset local gov- ernments' low tax capacities. Grant-s are also often given for specific pur- poses and special programs ("earmarked grants") to address deficiencies in public expenditures in specific expenditure categories. In general, the two objectives of revenue adequacy and horizontal equity cannot be met with only one approach. 3.17 Some transfer or revenue-sharing systems are also designed to encou- rage local tax effort or, at least, not to impair the local governments' incentives to raise taxes. For exarmple, in India, 10X of the allocation to provinces through formula grants, is given on the basis of tax effort. Box 3.1 shows the range of approaches to formula grants. 3.18 Each of the basic transfer approaches has disadvantages, and none will satisfy all the objectives of an intergovernmental transfer system. One solution is to mix the approaches in a single system. For example, many coun- tries such as India and Brazil use both eqtLalizing and revenue stimulative transfers in the same system. China in an International Context 3.19 There is no "normal" share of expenditures made by subnational gov- ernments. Political considerations, regional realities, constitutional requirements and administrative elements are al:L crucial to understanding the development of different systems. T'he most basic issue on the tax side is the command over resources by the various levels of government and the resultant independence (or lack thereof) of each governmental unit in meeting its expen- diture goals. The financial resources of each level of government depend on the division of tax powers. Because revenues and expenditures do not usually match, fiscal transfers are required to match resources with each level of government's expenditure responsibilities. Some countries find it to their advantage to give more fiscal powers and responsibilities to local govern- ments, while others chose to rely on the different forms of intergovernmental transfer outlined above. This section explores how China fits the interna- tional patterns and what it can learn from the experience of other countries.  - 77 - Box 3.1: FORMULA GRANTS Four basic approaches to allocating central revenue resources among local govern- ments are: (i) tax sharing, (ii) ad hoc distributions, (iii) reimbursement of the costs of specified undertakings, and (iv) by formula. Formula grants are popular because they are objective and easily understood, and because they give the central government the opportunity to target the distribution of funds among local governments in a way consistent with national policy. An added advantage is that as local governments outgrow their needs for revenue sharing, or as their needs change rela- tive to other local governments, the grant distribution is automatically adjusted by the for- mula and no discretionary government action is called for. Formula grants are usually pointed towards either a recognition of variations in expenditure needs or of differences in fiscal capacity, i.e., in the ability to raise revenue while making an average effort. Expenditure needs are proxied in many ways including per | capita income, population, infrastructure adequacy, and the like. Examples include the fol- lowing: The distribution of education grants in Colombia is based primarily on the popula- tion size of each Province. Philippine general purpose grants are distributed according to population and land area. Transportation grants to Brazilian state and local governments are allocated according to population, land area, and the consumption of imported fuels. The distribution of India's excise tax grant has made use of a poverty index. Grants to compen- sate some provinces for low income and low fiscal capacity are often distributed partially by the reciprocal of per capita income. This is done in Brazil and India. Yet other formula grant systems have explicitly included a tax effort measure to induce Provinces to increase their rate of revenue mobilization. (Examples are the US, Nigeria, India.) The disadvantages to the formula grant are that the choice of the grant elements can be influenced by politics. Moreover the choice of a formula may be limited to what data are available, and as such may reflect neither true expenditure need or fiscal capacity. More- over, detailed and timely data are almost never available at the local government level. Source: Roy Bahl and Johannes Linn; Urban Public Finance in Developing Countries; forthcom- ing. 3.20 On average, subnational governments in industrial countries account for about 30% of all government expenditures, compared to 15Z in the LDCs. This pattern has not changed significantly during the past two decades. It is difficult to say how China fits into this international pattern. The subna- tional share of government expenditures (about 55Z) and revenues collected (about 65Z) are well above these averages. However, taking the revenues which actually represent local revenues (a far smaller fraction than revenues col- lected, because almost all taxes in China are collected at the local level) the proportion of 'own revenues" is closer to 15% of total revenue.4/ Table 3.1 shows the range of experiences. 3.21 The Chinese system probably gives less formal fiscal autonomy to local governments than is the case in other countries. In most other coun- tries the fiscal powers of local governments are limited, although local fis- cal independence is greater in industrial than developing countries. In 4/ Own sources are defined as those revenues collected by local government for its own use, plus those taxes unconditionally assigned or which accrue automatically to local government. Own revenues include the agriculture tax; income tax from collectives and state enterprises owned by the subnational government; and a sales tax surcharge, plus a variety of smaller taxes.  - 78 - Table 3.1 IMPORTANCE OF LOCAL GOlVERNMENT REVENUE SHARE, SELECTED COUNTRIES (% of total revenues) Local government lLocal government 'own' revenues as Wown' revenues as % of total % of total Country government revenues CoLuntry government revenues Nigeria 28.6 Israel 11.4 Tanzania 21.7 Syria 6.7 Uganda 20.0 Turkey 2.2 Kenya 16.2 Zambia 8.8 Colombia 47.7 Malawi 3.7 Brazil 36.1 Venezuela 5.6 Dominican Republic 6.4 Korea 18.4 Panama 5.2 Philippines 11.2 Costa Rica 4.2 Sri Lanka 4.2 Peru 4.0 Indonesia 1.8 Australia 25.0 US 36.0 Germany 55.0 China 11.0 Canada 51.0 China -a 63.0 /a Measured on a accrual basis and includes only lownw revenues; i.e., those that accrue to local government before any sharing takes place. If data were presented on a 'collection' basis, local government collections would amount to about 85% of total government revenues. /b Collection basis. Notes: Data for countries other than China: 1970s. China: 1985. Source: R. Bird, wIntergovernmental Fiscal Relations in Developing Countries'; IBRD, 1976/1977. Data for inclustrial countries: Hunter, 1977, p. 104. developing countries, the tax bases available to local governments and maximum rates are usually fixed. Similar arrangements usually hold for adjusting user charges for most major services, e.g., water rates, bus fares, rents. Most LDC central or state governments have approval powers over local government budgets, and the extent to which this process reduces local fiscal autonomy depends on the tightness of the review process. Local government budget autonomy is also commonly hampered by central government expenditure mandates. The borrowing powers of local governments are quite limited in most LDCs. Though credit is made available to subnational governments under a variety of schemes, most local governments are given little discretion over the amount or purpose of the loan, the source of the funds, or the terms of repayment. 3.22 Another important limitation in deEining local autonomy has to do with the nature cif selecting local officials. For example, it may matter little that local governments have a broad range of fiscal powers if all sub- national financing and governance decisions rest in the hands of centrally- appointed officials. Again, a broad range of practices is follored, but cen- tral governments frequently make these appointments. 3.23 China provides significant Eormal limits to local goverrment auton- omy. There is virtually no local discretion as regards revenue raising; indeed purely local taxes cover less than one fifth of their expenditures, as Table 3.2 shows. Yet because the system gives local governments responsibil- ity for administering and thus implermenting the fiscal system, there is room for local governments to gain fiscal discretion by using informal methods, such as the granting of preferential tax treatment for enterprises.  - 79 - Table 3.2: TAX COLLECTION AND EXPENDITURE OF CENTRAL AND LOCAL GOVERNMENTS, 1980-86 L! (Billions of Yuan) 1980 1981 1982 1983 1984 1986 1986 1987 Centrally collected revenue 21.0 22.6 25.8 37.2 52.4 89.0 91.7 - Central government expenditures 65.0 60.2 57.5 64.2 72.8 81.9 98.2 - "Collections Deficit" -44.0 -41.7 -31.7 -27.0 -21.4 -12.9 -4.9 - Local government collections /b 87.5 86.4 86.6 87.7 97.7 117.8 134.3 - Local government expenditures 56.2 51.3 57.8 65.8 80.8 104.6 136.8 - 'Collections Surplusw 31.3 31.5 28.8 22.7 18.9 13.0 -2.5 - Local government Wfixed" revenue (est.) /c 11.8 11.6 12.5 15.3 15.9 19.0 - - /a The difference between the local governments' surplus and the central government's deficit is the central government's foreign borrowing and domestic budget deficit. /b Central and local government collections are before transfer from local governments to the central government. /c Defined according to the specifications of the system fixed for 1986-87. Includes the collec- tives' income tax, the agriculture tax, and estimated profits taxes on locally owned enter- prises. These three taxes are the major "fixed local revenues" fixed in the 1985-87 reform of the revenue sharing system. In practice, many of these revenues are shared with the central government (see para. 3.44). Source: MOF. According to national definitions of revenue and expenditure, and before any transfers or subsidies. 3.24 Most large countries in the world are organized as federalisms: India, Nigeria and Brazil are examples among the developing countries, and the United States, Canada and West Germany are examples from among the industrial- ized countries,, but China is not. This system, typically but not always, transfers controls over local finances from the central government to an intermediate level of government such as the State, Province, or Department. 3.25 There are strong arguments for and against the federal form. In populous and large countries where local preferences and needs vary widely, e.g., India and Brazil, it enables the central government to avoid direct dealings with a large number of urban governments. For example, the central government can use grant formulas to recognize broad differences in needs and preferences without having to take into account the specific needs of individ- ual cities, or it may simply assign responsibility for local finances to the provincial government. B. The Present System of Subnational Finance in China 3.26 Despite its size and diversity, China has chosen a unitary system of government in which the Constitution does not expressly delineate the powers and responsibilities of the various levels of government. Yet the central, provincial and local levels of government have distinct powers and responsi- bilities, and in many respects the Chinese system functions as a federalism. Fiscal behavior varies enough across provinces to contravene national uniform- ity in China. 3.27 China's system of intergovernmental transfers is an important compo- nent of total public financing, perhaps more so than in any other country.  - 80 - China's shared tax system based on sales and profits taxes makes revenue in principle responsive to growth in income and prices. The distribution of tax shares among Provinces is changing from a broad formula-based approach with an equalizing intent to an ad hoc approach characterized in recent years by sub- stantial negotiation and a variety of speciial purpose discretionary grants. The Chinese system does not make use of catesgorical or cost reimbursement grants to stimulaEte spending for particular purposes, and while there are special purpoSE! grants, there are no formula-based grants which take account of the populati-on characteristics of Provinces. China does use rnatching grants. Provincial Government Finances 3.28 In the Chinese system, the central government has direcl: relations with Provincial governments. This system is roughly described in Figure 3.1. All governments, within a Province report directly (or indirectlyl to the Pro- vincial government, and carry out their duties subject to Provincial regula- tions. This system of vertical relationships creates a setting within the Province allowing a degree of fiscal decentralization to the local government level. For example, in Zhejiang Province alt the end of 1985, there were 8 provincial cities (municipalities), 66 counities, 3 county-level cities, 3 prefectures and 508 towns. 3.29 In some ways, the Chinese fiscal system is as decentralized as its governmental structure. Municipal and county governments' tax bureaus directly assess and collect about 70Z of all taxes.51 Expenditure responsibility is: less decentralized in thalt provincial and local governments account, on average, for over 50Z of total direct expenditures. Only a few countries in th,e world can claim as great a degree of expenditure or revenue decentralization and none can claim this degree of decentralization in tax administration.61 Table 3.2 shows recent trends in the revenues and expenditures of central and subnational governments. f 3.30 The central government spends more than it collects. Central govern- ment expenditures, until recently, amounted to half or more of publicly bud- geted outlays. I'he central government's major areas of expenditure responsi- bility are defense, foreign affairs and foreign aid, national uniLversities and research, central ministries, general administration, and large iLnvestment projects. In addition, the central government provides revenue transfers to poor provinces. 5/ Note that no information is available on- revenues which actually accrue to subnationaLl governments, after sharing with the Center. 6/ The comparable ratios for the United States--which is a decentralized fiscal system by world standards--are 43Z of taxes collected and 42Z of expenditures made by state and local governments. The ratio of subnational to central government expenditure exceeds 75Z in Denmark, Australia, Switzerland, Italy and Canada, but subnational govrernment revenue autonomy is more limited. Roy Bahl, "The Design of Intergovernmental Transfers in Iindustrialized Countries," Public Budgeting and Finance, Winter 1936, Volume 6, Number 4, pp. 3-22.  - 81 - Figure 3.1: GOVERNMENT STRUCTURE IN CHINA Central Gove rnxnent (Urban) co(Rural) dietl ubrint t hePovnia ovrmet 3 Munici balities o t Prefecturesie C ty Urban p Nonurban Proper Counties la | Counties (District)E 9 | ~~~~~~~~Towns/| |VillagesI /a In some provinces, and in some special cases, urban counties may be directly subordinate to the Provincial government. 3.31 The responsibilities of the provincial and lower-level authorities include their own investment projects, and most, but not all, public expendi- tures on education and health, local administration (and tax collection), culture, science and agricultural support, including irrigation, agricultural research, extension activities, and other rural expenditures. Since the inception of the economic reforms, there has been a gradual trend towards decentralizing expenditures, with the central government's share in total outlays declining and a corresponding increase in the expenditure share of local governments. Consequently the center's share of total expenditures has been declining from about 50Z of total expenditures to 41Z (Tables 3.2 and 3.4). Little is known, however, about the types of expenditure shifts which have taken place. 3.32 Degrees of Autonomy: Revenues. Revenue collection and expenditure disbursement are not the only dimensions of fiscal decentralization and one  - 82 - can find many areas where fiscal decisions are subject to substantial central control and direction. By comparison with most countries in the world, subna- tional governments in China have litt:le formal, or legal independence in mat- ters of structuring their tax system or deciding on the level and composition of expenditures. All tax rates and bases are set centrally and so there are no truly local taxes--defined as those whose rate or base the subnational government can unilaterally fix--at the subnational level.7/ Moreover, the central government determines, for each province, a share of taxes to be turned over to the center. In effect, subnational tax collections in China are central government taxes whose revenues are allocated among provinces, municipalities and the central goverrnment.8/ 3.33 Even with this degree of centralization in the rules, subnational governments have an important impact on spending levels and on the amount of revenues raised within their provincial jurisdiction. This follows because Provinces design and implement the system of intergovernmental relations between the province and local governments. In particular, provinces deter- mine the share of tax collections that will be retained by each local govern- ment. The allocation of loans to local enterprises and the distribution of grants to local governments are also determined by the provincial government. Moreover, because provinces can set the tax sharing rates for each local gov- ernment, they may also indirectly affect the relative rate of tax collection or tax effort the local administration makes. This in turn gives local gov- ernments a substantial degree of autonomy to affect the level and composition of taxation, public service delivery and capital investment. This autonomy arises from the fact that they control tax collection and assessmient with apparently a minimrum of direct central or even provincial supervision. Responsibility for implementation of the tax system is a very powerful policy instrument in the hands of local government and indications are that they use it. 3.34 Expenditure Autonomy. Autonomy on the expenditure side of the budget is limited for provinces. Subnational government budgets are determined as part of a consolidated central, provincial and local budget and as such must satisfy the (negotiated) fiscal targets laid down by higher level government. The budgetary choices of provincial governments are further limited by expen- diture rules, mandates and monitoring by higher level government. 3.35 Within the province, there is more room for discretion. At the local level, provincial governments are responsible for approving the budgets and financial plans of municipal and county governments. This means they can control the spatial distribution of expenditures within the provirnce. There appears to be great variation in the system of province-local relations across 7/ Local governments are entitled to set surtax rates on a variety of taxes, as described in Annex 1. Local governments can also design and collect a set of extrabudgetary fees, and charges. 8/ It also should be noted that a number of other important finarLcial measures and regulations are strictly prescribed by the central government and are followed with :Little variation, such as the! allocation of foreign exchange earnings between the general government and enterprise sectors.  - 83 - provinces, suggesting that provincial governments have significant room to adjust fiscal decisions to accommodate local needs and preferences within the parameters set by the central government. (Provincial/local relations are described in paras. 3.58-64.) 3.36 Within the system of "vertical" responsibility, each province must account to the center for its activities. In this process of vertical accountability, the following principles restrain, or guide, budgetary choices of provincial governments: (a) there cannot be a deficit; (b) current expen- ditures to maintain infrastructure have the highest priority among urban construction-related expenditures; (c) the provision of social overhead facil- ities such as education, scientific research institutes and hospitals take a high priority; expenditures on culture and education are mandated to increase by at least the same rate as total expenditures; (d) employment levels and wage rates are fixed by the central and provincial governments; (e) all reve- nues from the urban maintenance and construction tax must be spent for urban maintenance and construction, i.e., for public utilities and public facili- ties. Budgeting and Financial Planning 3.37 In theory, China has a unified system of budgeting--covering all accounts--in which all the financial plans and accounts of the central and subnational governments are jointly presented.9/ Because the Chinese budget consolidates the budgets of all three levels of government, no budgetary breakdown has been made available showing central revenues separate from those of the provinces. Each provincial government in principle also has a budget which includes the budgets of all lower level local governments, but, at least in the provinces visited for this work, it is not fully unified, being neither detailed nor complete. 3.38 Because government budgets are not fully unified in the sense of including all revenues and expenditures, it is difficult to construct an estimate of the total amount of revenues raised or expenditures made by the subnational governments or in particular local areas.10/ For example, extrabudgetary revenues and expenditures (nonplan) are reported in the budget, along with budgetary receipts and outlays. However, departmental revenues and grants received are generally not reported in the accounts. The transfers between, and overlaps among, the budgets of the government, the SOEs and public utilities are not apparent, especially for local government: Some examples include those transfers to the SOEs which are included under "technical transformation" in the provincial budget (without distinguishing 9/ "Unified" budgeting is used here to mean a budget which incorporates all accounts of the government unit. "Consolidated" uses the Chinese terminology and reflects the joint presentation of the budget of all levels of government. IO/ This absence of a unified budget at the local level has its parallel in the Consolidated Budget of the MOF in which a variety of extrabudgetary expenditures, revenues and accounts are not reflected (see Chapter I and Box 1.2 on "Recasting the Chinese Budget").  - 84 - grants and loans). Other transfers to cover SOE losses are shown as an expenditure in the general provincial budget and not as a transfer, unless the loss is "unplannecd," in which case it is shown as negative profits tax revenue (i.e,, it is subtracted from revenues, paralleling the approach in the consolidated MOF Budget described in Box 1.2). Grants to provincial and local governments do not appear to be shown separately in the budget. 3.39 With regard to the distinction made in some countries between capital and current budgets, each local (urban) government has a regular budget and a construction budget, but these do not correspond to a division of current and capital expenditures, and there is no separate reporting of capital financing. Tax Administration 3.40 Provinc:ial governments cannot vary the nominal rates of tax, nor may they redefine the legal tax base. However, they have almost complete autonomy in assessing and collecting taxes, and along with the lower level county gov- ernment can and do give tax relief without having to seek approva]L from the Center. One could fairly say that subnational governments can substantially alter the level arLd pattern of effective tax rates paid by enterprises. 3.41 The organization of tax administration in China centers around the activities of two organizations: the Tax Bureau and the Finance Department. In theory, these bureaus are at the same time organs of the central and local goverrnments. Th1ere are separate Tax Bureaus and Finance Departments at the city, county and province levels. The functions of the Tax Bureau and the Finance Department. seem clearly distinguishable in principle. The Finance Department conducts tax policy allowed by law at the provincial and local levels, and manages the expenditure side of the budget. The Tax Bureau is responsible for implementing central tax law and collecting taxes.. In prac- tice, the division of responsibility is not so clear, and the directives given to the Tax Bureau by the central government and its subnational government are not always consistent. Many of the Tax Bureaus' actions in the provinces visited for this work suggest substantial tension as a result of t:his system of "dual leadership". Also it appears the Tax Bureau is more likely to act as an agent of the provincial or local governments than of the central govern- ment. The Finance Bureau clearly plays a leadership role within the provin- cial and local governments. 3.42 Provincial and local governments have a surprising amount of discre- tion in granting tax relief. Their activities in this regard are referred to as the policy of "stimulating enterprise through tax expenditures" where three methods of granting preferences are used. F.Lrst, if the provincial government wants to promote a new product or a pioneer industry, it may authorize a reduced tax rate or a tax holiday for a number of years (usually not to exceed five years). Second, the Finance Bureau may enter into a contract. arrangement with an enterprise for payment of a negotiated amount of taxes. I'hese were described in Box 1.1 on the Contracting System. Third, the Tax Bureau may grant ad hoc tax relief to enterprises on a case-by-case basis depending on the needs of the enterprise. There is every indication that they use this discretion to promote the economic development of the local area, even though  - 85 - the preferences granted sometimes do not conform with the objectives of the central government and seriously impair its revenue. Provincial and Local Revenues 3.43 Provincial governments have four revenue sources: shared taxes, extrabudgetary funds, user fees and capital finance. China's revenue sharing system is primarily a division of sales and profit taxes among the central, provincial, and local governments. Whereas in most countries the taxes are collected by the central government and then allocated to the lower level subnational governments, in China they are collected by the local governments and "shared-up" to the higher levels. The amount of shared tax revenue finally going to the provincial government budget depends on the tax base and rate, tax administration, and the sharing formulae. The amount finding its way into the central budget depends on provincial receipts, and the sharing formula between center and province. The sharing formulae, therefore, has two elements: the proportion of revenues from any given tax shared between center and the province, and the sharing method for the tax and its distribution amongst local governments within the province actually doing the collecting. To understand the revenue-sharing system in China, one must understand all of these dimensions. 3.44 Tax Revenues. By law, there are three categories of revenues--"fixed central government revenues," "fixed local government revenues" and "shared revenues." Box 3.2 shows the principal taxes in each of these categories prior to the 1988 proposed changes. Revenues collected from local taxes are, in principle, assigned fully to the local government and are referred to as "local fixed revenues." Rate determination and base definition, however, are not under local control. In practice, however, most "local fixed" and "shared" taxes have been subject to sharing apparently because adherence to these categories caused a revenue shortfall to the central government. Since the mission visited China in May/June 1988, certain minor changes have taken place in the allocation of these taxes to different levels of government. Because these are minor taxes, it is unlikely that these shifts would affect the report's analysis or recommendations.ll/ 3.45 Extrabudgetary Funds. Other sources of revenue for provincial gov- ernments, earmarked for capital purposes, are extrabudgetary funds.12/ Extrabudgetary revenues of the government itself are relatively small compared 11/ Exceptions are the UMCT and a few other local taxes, which are retained locally. The detail on the proportion of each tax that is shared, central, or local is provided for 1987 and 1988 in Annex 2, Tables 3 and 4. 12/ This figure excludes the extrabudgetary funds (retained profits) of the SOEs. These include a set of taxes and charges that are controlled by the local or provincial Finance Department, the most important of which is the public utility surcharge--a 10Z tax on the utility bills of consumers. There also are some minor taxes and charges in this category, including the surcharge on the agricultural tax, revenues received from public housing and public property, and some institutional income that accrues to the various city enterprises.  - 86 - Box 3.2: REVENUE Al-LOCATION AND TAX SHARING I. wFixed Central Government Revenuesw: 1. Income and adjustment tax of all central government enterprises. 2. Business tax from raiIroads, banl and insurance company headquarters. 3. Profit remittances by all enterprises producing arms. 4. Price subsidies paid to producers of grain, cotton and oil (treated as a negative revenue of the central government). S. Fuel oil special tax. B. Income taxes, sales taxes and royalties from offshore oil activities of foreign companies and joint ventures. 7. Treasury bond income. 8. 70% of the three sales taxes collected from enterprises owned by the Ministry of Industry, the Ministry of Power, SINOPEC, and the China Nonferrous Metals Com- pany. 9. All customs duty and all VAT and product taxes collected at customs. 10. Tobacco Tax and Business Tax on Tobacco. 11. Product tax on liquor and tobacco. II. In 1985-87, the wlocal fixed revenues"' were as follows: 1. Income tax and adjustment tax of locally-owned enterprises. 2. Income tax from collectively owned enterprises (ICIT). 3. Agricuilture tax. 4. Rural market trading tax levied on private sector traders. 5. Local government grain trading loss (a negative tax). 6. Fines for delinquent taxes. 7. The Urban Maintenance and Construction Tax (UMCT).1/ 8. Housing tax.2/ 9. Vehicle utilTzation tax. 10. 30% of the sales tax revenues collected from enterprises owned by thie Ministry of Power, SINOPEC, and the China Nonferrous lMetals Company. 11. Individual income tax. 12. Wage bonus tax. 13. Self-employed Entrepreneurs Tax. 14. Slaughter Tax. 15. Cattle Trading Tax. 16. Contraict Tax. III. Taxes sharerd between the central and local governments: 1. All sales taxes (value-added, business, anid product) revenues from all enterprises, except those expressly excluded as described above under 1.6, I.9, I.10. 2. Natural resource taxes. 3. Construction tax. 4. Salt tax. 5. Industrial and commercial tax, and income tax, levied on foreign and joint venture enterprises. 6. Energy and transportation fund taix. 1/ The UMCT is set at 7% of total sales tax liability for municipalities (5% for towns and 1% everywhere else) 2/ Private, owner-occupied housing and government buildings are exempt and the Housing Bureau pays at a preferential rate of 12%. Payments by enterprises are deductible from adjust- ment tax liability. On foreigners, it is called the wreal estate tax' and is equal to 18% of rental value or 1.2% of capital value. Land is not taxed, only the buildings. to other provincial and local revenue sources, and account for only 3Z of total extrabudgetary funds (enterprise retained earnings are about 80Z and extrabudgetary revenues of government: agencies are about 17Z) and less than 1.6Z of government budgetary revenue. 3.46 User Charges. Though the public utility enterprises attempt to recoup a portion of costs through user charges, there has been no strong sen- timent to raise rates to efficient (marginal cost) levels. Cost recovery is a  - 87 - much bigger matter than simply raising the level of the user charge. Water, sewerage and gas (LPG) charges, bus fares and housing cannot be adjusted inde- pendent of national wage and price policy and enterprise and tax reform pol- icy. Perhaps as important, but less widely recognized, is the relationship between increasing the rate of user charge and the sharing of revenues among the three levels of government. An increased user charge--paid by enterprises or by individuals and compensated by an increase in wages--will lower the profits and therefore the tax liability of enterprises. The result will be a shift in revenue power (a) from the central to the local level because the whole of the user charge "stays at home," and (b) from the general government to the public utility enterprises. Unfortunately, no data are available for making a good estimate of the percentage of total costs recouped by user charges, but it is probably quite low. Residential user charges have changed little since Liberation, though there has been some movement in rates charged the enterprises. Within limits set by the central government, local govern- ments can increase rates, and have done so for commercial and industrial users. 3.47 Capital Grants and Borrowing. China has no regular, formula grant program to support capital projects; all grants are on an ad hoc basis. There is no mechanism or formal program for lending to local governments, and there is no formal mechanism that guides local governments in developing bene- ficiary financing schemes. Capital financing is done from some combination of current revenues, planned loans or grants, special exceptions to the restric- tions on borrowing, and creative, ad hoc approaches to benefit financing. 3.48 Provincial and local governments in China cannot borrow. However, there appear to be ways to avoid these restrictions. Short-term borrowing (less than one year) and even some longer term credit financing does occur. In some cases, municipally owned enterprises borrow for infrastructure proj- ects and in some cases the municipal government has pledged its general reve- nues to secure loans to its enterprises. 3.49 The "price" of capital construction is high because it must be financed from current revenues rather than loans, i.e., by current rather than future beneficiaries; and by the general public rather than direct beneficia- ries. Intergovernmental Fiscal Relations 3.50 There are three important dimensions to the system of intergovernmen- tal fiscal relations in China. The first is the system of tax sharing, out- lined above, which determines the amount of resources that will be allocated to the subnational government sector. The second is the distribution of these funds among provinces, and includes both the tax sharing formulae and the flow of grants and subsidies. The third is the system of horizontal fiscal rela- tions within the province, the method by which the provincial government allo- cates fiscal resources among its counties and municipalities. 3.51 Central-Provincial Transfers. The central government fixes and adjusts the tax sharing arrangements with the provinces. The system in China is essentially a sharing of revenues from a specified set of taxes, almost all of which are collected by the local governments. The total amount of the  - 88 - distributable pool is determined prirnarily by the amount collected from these taxes, but the distribution among provinces is determined by a combination of (a) origin of collections, (b) formu:la, and (c) negotiation and ad hoc deci- sions. The latter has given rise to the so-called "provincial contracting system" in which most provinces contract with the central government to permit an agreed revenue amount or proportion. 3.52 The basic retention formula was most recently amended in 1988. The retention rate may be either positive or negative and determines, in princi- ple, whether the province remits a share to the center or receives a subsidy.13/ Some provinces do not operate under a retention ratio, but contract with the Center for a fixed delivery quota. T'his was; part of the reform of the system begun in 1988, under the name of 'provincial contracting". The results of applying the retention rate are described irL Table 3.3. For example, Beijing in 1987 would be able to retain 49.5Z of its 1987 collections from shared taxes. This system was intended to give provinces an incentive to collect taxes on behalf of the Center, by giving them a 'Larger fraction of total col- lections. Of course, all fixed central government revenues would be turned over to the Center. As may be seen from the Table (Col. 3), 13 provinces had a "collections surplus" in 1987, i.e, shared plus local fixed revenues exceeded allowable expenditures and t:he tax sharing ratio was unity or less. 3.53 The remainder of the provinces were, in 1987, deficit provinces (see Column 6). The eight autonomous regiLons, the provinces with heavy minority populations and those least developed are singled out for special treatment. They receive a subsidy equal to their calculated deficit and this amount was to be increased by 10X per year, a fiLgure taken roughly to approximate needed revenue growth. This system is knownl as the 'minority budget system". In four other cases, the provinces under a "deficit province system" were allowed to retain all fixed and shared revenue collections and the central government paid a subsidy equivalent to the size of their 1986 deficit. 13/ The formula planned for 1988 is: (L86 + S86) (RATIO 83) - T88 Retention Ratio 88 = ------------------------------ (L86 + S86) - T88 where S86 = shared revenue in 1986 L86 = "local fixed revenue' in 1986 T88 = the 13 taxes assigned to local governments in 1988 Ratio 83 = Allowable expenditures in 1983 * Actual revenues collected in 1983. This simplifies to (E83)(1+r) - T88 Retention Ratio 88 = ----------------------- S(86) + (L,86 - T88) This formula has been adapted a number of times since 1984. Full details of these changes are provided in Annex 2. Among the reasons for the change are the transfer of enterprises from provincial to central ownership.  - 89 - Table 3.3: CHINA: REVENUE-SHARING SYSTEM BETWEEN THE CENTRAL AND PROVINCIAL GOVERNMENTS, 1985-1987 Fixed percentage Province retained Province /b of total revenue all revenue collected retains all own reve- Fixed or Provinces collected is and received agreed nue and pays agreed contract and regions retained by Province amount from the Center /a amount to the Center delivery 1986 1986 1987 1985 1988 1987 1985 1986 1987 1988 --- (%) ------- ------------- (In millions of yuan) ------------- North China BeiJ ing 48.2 49.55 49.55 ** Tianjin 39.5 39.45 39.45 ** Hebei 89.0 72.00 72.00 ** Shanxi 97.5 97.50 97.60 N.A. Inner Mongolia 1,783* 1,981.74 2,059.83 N.A. Northeast China Liaon7ing 61.1 52.88 52.88 N.A. Jilin 397 398.62 398.62 Heilongliang 96.0 142.70 142.0 N.A. East China IiFenhFi 26.0 23.64 23.54 ** Jiangsu 39.0 41.00 41.00 ** Zh-jiang S5.0 55.00 60.81 ** An Hui 80.1 80.10 80.10 Fujian 235 234.86 234.88 N.A. Jiangxi 239 239.46 239.46 N.A. Shandong 69.0 77.47 75.0 N.A. *entrai/South China Ronan 81.0 81.00 87.10 N.A. Hubei 66.5 100.00 100.00 N.A. Hunan 88.0 88.00 88.00 N.A. Gangdong 772.00 778.08 778.00 ** Guangxi 716* 788.03 827.43 Southwest China Sichuan 89.0 100.00 100.00 N.A. Guizhou 743* 817.57 858.46 N.A. Yunnan 637* 925.88 972.17 N.A. Tibet 760* 825.32 868.59 N.A. Northwest China Shaanxi 270 270.26 270.28 N.A. Gansu 248 245.80 245.60 N.A. Qinghai 611* 871.88 705.47 N.A. Ningxia 494* 543.14 570.30 N.A. Xinjiang 1,450* 1,594.86 1,874.59 N.A. / Asterisk indicates subsidies were to increase by 10% per year after 1985. Two asterisks indicate quota contract delivery, also known as wprovisional" contracting. N.A. Information not available for the province's arrangements with the Center for 1988. Source: Data Supplied by MOF. 3.54 A "provincial fixed contracting quota", or "incremental sharing rate" on revenues above a target level applies in some provinces. Since 1988, it has been applied in provinces including Jiangsu, Zhejiang, Hebei, Beijing, Tianjin, Guangdong and Shanghai (see Column 10). Under this system, a base quota of shared revenues must be transferred to the central government while all (or part of the) revenues collected over and above this quota may be kept by the province. The purpose of this special program, which can provide for up to 1002 retention of above-quota collections, is to give these provinces-- seen as keystones of China's development because of their outward orientation --greater incentive to collect tax and scope for growth. Within this group,  - 90 - Guangdong and Shanghai are among those to receive this special treatment. Guangdong is allowed to retain all taxes collected, after it reinits to the Center a fixedcl quota. Shanghai remits Y 10.5 billion to the Center and retains any excess. Five other provinces (shown with ** for 1988 in Table 3.3) are also under this "provincial contracting system", but the contract targets are not known for these provinces. 3.55 While t:he provincial contracting arrangements can--if ithe above-con- tract share is low--provide increased incentives to collect revenue, they do not eliminate the potential conflict of interest between local and central governments, nor does it alleviate a crucial problem associated with decen- tralization, that is, the loss of control and flexibility by the Center over the use of tax policy for macroeconomic purposes referred to in Chapter I. 3.56 Moreover, the provincial contracting system, if more widely applied, can lead to severe revenue consequences. The fact that most contracts are fixed in nominal. terms has left an increased share of fiscal resources in the hands of local governments. This reduces the growth, and, potentially the real volume, of resources in the hands of central government. Finally, as noted in Chapter I, like enterprise contracting, the provincial contract arrangement introduces a pro-cyclical bias to the fiscal system. This occurs because the revenue received by the centraL government under the nfixed remit- tance" contract system remains relatively constant regardless of the underly- ing growth of economic activity. 3.57 Implementation of the System. While the formulas themselves are not very complicated, the revenue sharing system is not simple to administer. Three problems are worth considering. First, implementation of the system requires reporting a substantial amount of detailed fiscal data by the prov- ince and verification of accuracy by the central government. Provinces do not appear to gather detailed fiscal data from their local governments, and the central government does not have a good mechanism for monitoring available data. Second, and contrary to goveirnment iLntentions, the sharing rates are not fixed for a specified number of years and negotiation and barter by the provincial governments are possible. Thircd, the actual transfer of the funds poses an administrative problem. Under the present system the EPeople's Bank appears to be the fiscal collection agent and deposits the monthLly or quar- terly amounts to the appropriate central, provinacial or municipal/county accounts, based on the sharing formulas. Tax Sharing Between Provinces and Their Local Governments 3.58 Provincial governments set the general rules defining revenue sharing among local governments within their jurisdiction. They receive no guide- lines from the Central Government for setting the sharing rates and are con- strained only by their own economic plans, the total amount available for sharing, and provincial politics. tNot surprisingly, provincial governments have developed many different systems. 3.59 Revenue Sharing. The approaches taken in Jiangsu and Anhui Province illustrate some of the differences. Jiangsu Province shares with each local  - 91 - government a flat percentage of its tax collections that varies across locali- ties.141 The sharing rate is determined on an ad hoc basis for each of the 11 cities and is reported by provincial officials to be equalizing, with cities in the poorer southern parts of the Province and those in more remote loca- tions having higher retention rates. 3.60 The city governments in Jiangsu in turn determine the tax sharing rates for their urban counties, though the Province may stipulate the average sharing rate for an entire urban region. For example, the average retention rate for Nanjing and the counties under its administration may not exceed 22%. Changzhou, where the provincial government assigns the county retention rates directly, is the one exception to this general rule that cities determine the urban county tax retention rates. 3.61 Jiangsu has a special fiscal arrangement with the Provincial capital, Nanjing. Because it is the highest income city in the province, its basic retention rate of 17.5% is the lowest in the Province, but Nanjing is allowed to retain 30% of collections above the previous year's amount. It is note- worthy that although Jiangsu has benefitted from the increased provincial/ central "incremental retention" rate in the last two years the Nanjing incre- mental retention rate has not been increased. 3.62 Anhui Province offers another example of the complexity of provincial relations. The local government's base year 1983 revenues and expenditures are used to fix the revenue retention ratio (E/R). However, an "incremental formula" applies to local revenue collections above the base level, where the local government retained share is lower and the provincial share higher than the basic ratio. Clearly, this system does not give local governments an incentive to increase their rate of revenue mobilization. A subsidy is paid to the local government if base expenditure exceed revenues. Apparently, the province attempts to allocate resources amongst local governments on an equal- izing basis. The counties surrounding Hefei have an incremental retention rate of 80Z, nearly 90Z of the counties retain all revenues collected and receive a subsidy, and smaller cities have a higher incremental retention rate than larger, and presumably higher income, cities. 3.63 Like Jiangsu, there is a special arrangement for the provincial capi- tal of Hefei based apparently on a special contract basis. The city's basic retention rate is 14.93%, and its incremental retention rate is 27Z, for an average retention of about 22Z of total shared tax collections in 1987. 3.64 Provincial Grants. The other dimension of Provincial finance is grants to the local governments. The concept of a grant-in-aid (as distinct from a price subsidy for agricultural products) to a local government is not one with which provincial officials in China are accustomed to working. There is no regular, formula-based program of grants to local governments. Three classes of grant appear to be used: (a) earmarked grants for purposes such as capital construction projects, natural disasters, and special assistance for underdeveloped regions; (b) grants for "year-end reconciliations,' e.g., to compensate local government for a change in ownership of an enterprise during 14/ Some provinces, such as Zhejiang, have a different sharing rate for each tax.  - 92 - the year; and (c) subsidies to particular local governments for special pur- poses, includinag deficit grants. Apparently, the total amount allocated and the distribution among local governments is determined on an ad hoc basis rather than by formula. C. Initial Assessment and Issues 3.65 The Chainese system of intergovernmental relations is complex, and very responsive to provincial interests. The ostensible objectives of the system are to improve resource mobilization, to improve provincial tax effort, and to achieve fiscal equalization. How well the system achieves these goals --in the context of balancing local and central command over resources--is discussed below. 3.66 Shift:ig Fiscal Balance. The fiscal balance between the central government sector and the provincial-local government sector appears to have shifted. Table :3.4 shows recent trends in the collections and expenditures of central and local governments. Inasmuch as data were not made available on the actual division of revenues between local and central govermnents, the discussion below focuses on collections. The central government's share of collections has been increasing, from about 23Z of total collections in 1982 to 40Z in 1986 (line 1 of Table 3.4). This shift resulted in part from the transfer to the Center of state enterprises in certain sectors whlose profit taxes now accrue directly to the Center. Also contributing to thlis shift were the centralization of certain indirect tax revenues (petroleum, petrochemi- cals, nonferrotus metals, and electric power) and the rapid growthl of import duties. Table 3.4: CHANGING FISCAL IMPORTANCE OF THE CENTRAL AND SUBNATIONAL GOVERNMENT SECTORS (%) 1982 1983 1984 1.986 1988 1. Central Gov. share of collections (% of total) 23.0 29.8 34.9 37.0 40.5 2. Central Gov. share of expenditures (% of total) 49.9 49.6 47.8 43.3 41.3 3. Center expenditures as % Center collections 222.8 172.5 141.0 11.6.7 104.9 4. Subnational expenditures as % subnat. collections 66.7 74.1 82.7 88.9 101.8 5. Subnational transfer as % Subnat. collections 33.3 25.9 17.3 11.1 -1.8 Ratio of Collections to GDP: 8. Provincial Government 17.1 16.6 14.4 14.1 13.3 7. Central Governmnent 5.1 B.6 7.8 8.3 9.7 Note: The figures refer to centrally (and locally) collections and not to actual revenues, by each level of government, before grants and revenue transfers. "Revenues' and expenditure are by national, not GFS definitions and therefore differ from the figures shown in Chap- ter I. Source: Ministry of Finance.  - 93 - 3.67 The shift in the Center's share of total expenditures and revenues is a very important change. The result is that the provincial-local sector is becoming increasingly independent, and "revenue entitled", in that the reve- nues previously passed on to the Center are now retained at the local level. Whereas in 1982, provincial-local governments passed an amount equivalent to about one-third of what they collected (line 5), by 1986 the transfer was 2Z less than total collections. Or to put it another way, they spent 66X of their collections in 1982, while in 1986, they spend more than they collect. 3.68 The central government, on the other hand, was spending 2.28 times the amount it collected in 1982, that is, it was then highly dependent on revenue transfers passed up from the provinces, but it spent only 1.04% of collections in 1986. This decline comes partly from the central government increasing its share in revenue collections (through the shifts described earlier), in the context of a marked overall decline in total collections but also because of the reduced local transfers to the Center (line 5). The implications for central expenditures are shown in line 2, which shows there has been a shift away from the central sector in favor of provincial-local government expenditures. Overall, the Center's expenditure capacity has thus been curtailed. Indeed local expenditures have grown at an annual rate of 13Z, compared to a rate of 4Z for central government. (No data is available on the type of expenditures accounting for these changes.) If provincial and local governments had been held to their 1982 transfer ratio of one-third, the central government would have had an additional Y 46 billion available in 1986. 3.69 These statistics suggest a number of conclusions and raise a number of policy questions. First, the Chinese system has become increasingly cen- tralized on the collection side (line 1). A second observation is that the system is becoming increasingly decentralized on the expenditure side (line 2). Is the revenue decline by design or is it because local revenue efforts are flagging? Provincial and local government collections have fallen as a percent of GDP from 17% in 1982 to 13.3Z in 1986 (Table 3.4). This could be a result of increased preferential treatment by local tax administration offi- cials, but it also could be due to central government pricing or quota poli- cies that reduce enterprise profits and gross receipts. The central govern- ment's share in collections, meanwhile, has increased from 5Z to 9.7% of GDP. Is the decentralized expenditure shift due to reform priorities or due to a constrained central revenue system, due to declining transfers? 3.70 A third observation is that whether by design or not, each sector is now spending about what it collects. One is tempted to conclude that locally collected (as distinct from actual accrued revenues) taxes--the shared and local fixed taxes plus the local government tax collections from central enterprises--are the 'right" revenue volume for subnational governments. This needs only be supplemented (as it is now) with some system of horizontal transfers among the provinces. 3.71 An important implication of these shifts in favor of the subnational government sector is that the central government's ability to use discretion- ary policy to redistribute among provinces, or to centralize national finances, is much more limited.  - 94 - 3.72 Fiscal Disparities between Provinces. There are wide disparities in per capita revenue collections among the provinces, ranging from Y 1,492 in Shanghai to Y 52 in Guangxi and Y 4CI in Tibet, with an average of Y 169 in 1985 (see Appendix Table 4). What causes such great disparities in per capita collections among the provinces? The answer almost certainly is that higher levels of revenue mobilization are related to higher levels of economic activ- ity, and perhaps to a higher rate of urbanization. The four provinces with highest per capita income collected the greatest per capita revenue amounts, while low income provinces collected the least. The relationshilp between per capita revenue and per capita gross output is so strong that the four prov- inces with the highest level of per capita output (Shanghai, Beijing, Tianjin, and Liaoning) collected 31Z of revenues even though they account for 6.42 of the national population. This relationship is confirmed in a more systematic way by estimating the relationship between per capita collections and per capita gross value of output, holding constant population and urbanization (see equation (1), of Table 3.5).15/ 3.73 Disparities are also pronounced on the expenditure side, with a per capita variation around average expenditures of Y 152 ranging from Y 346 in Shanghai and Y 344 in Beijing to Y 63 in Sichuan and Y 66 in Anhui. The same four high income provinces account for 15.2Z of expenditures. HiLgher income provinces are able to spend more because of some combination of a greater demand for public services (proxied by urbanization), and the ability to raise more "local fixed" and extrabudgetary revenues (proxied by per capita output; see equation 2 of Table 3.5). Revenues appear to stay where they are genera- ted. Populous provinces spend significantly less on a per capitaL basis, even after controlling, for the amount of gross value generated and theb demand for public services (as proxied by the rate of urbanization). One interpretation of this result is that more services are provided in the less populous as well as in the more urban provinces, and that the second, urbanization, variable does not adequately control for the :Large rural population. 3.74 Examining the equalization features of the tax-cum-transfer system shows some interesting results. The relationship between the expenditure- collections ratio 16/ and output and urbanization variables shows this ratio is lower in high income or urban provinces (see equation 3 of Table 3.5). Thus, the transfer system helps to equalize in some sense the expenditure capacity (as proxied by this ratio) between rich and poor provinces although it does not, of course, equalize expenditure levels, as shown by the results of equation 2 above. As equation 3 shows, moreover, the retention rate also appears to be lower in provinces with large populations, cet. par., and this may not be equalizing. As measured by the gini coefficient, the disparity 15/ Ordinary Least Squares estimates. See Annex 2 for a detailed discussion. 16/ This ratio might be viewed as an approximation of the global retention rate on revenues collected. It should not be confused with the formal tax retention rate. The retention rate we calculate here includes fixed local revenues and collections from central government enterprises in the denominator, and it includes all budgetary expenditures in the numerator.  - 95 - across provinces in per capita expenditures (.34) is less than the disparity in per capita collections (.54). Table 3.5: OLS REGRESSION RESULTS FOR CHINESE REVENUES AND EXPENDITURES AGAINST SELECTED INDEPENDENT VARIABLES: BY PROVINCE FOR 1985 REGRESSION COEFFICIENTS /a X of Logarithms Per Capita Population Equa- (L) or Output Living in Popu- tion Dependent variable Linear (N) Constant (100 RMB) Urban Areas lation R2 N 1. Per Capita Collections L -6.S08 1.391 0.314 0.053 (7.06) (11.790) (2.241) (1.052) ... 0.91 29 2. Per Capita Expenditures L 5.433 0.436 0.106 -0.443 (11.38) (8.154) (1.362) (-14.783) ... 0.93 29 3. Ratio of Expenditures L 6.739 -0.558 -0.168 -0.308 ... 0.82 29 To Collections (11.322) (6.315) (1.728) (8.242) 4. Ratio of Collections N 0.069 1.614 (E-06) 0.0002 To Total Output Value (6.454) (6.168) (0.600) ... ... 0.63 29 la T-statistic shown in parentheses below the regression coefficient. 3.75 In summary, there are very great fiscal disparities among the Chinese provinces. Revenue collections are highly concentrated (41% of collections in five provinces) and per capita collections in the highest province are 37 times that in the lowest. The transfer system helps to equalize expenditure capacity in that the expenditure-collection ratio varies from over 400Z in Qinghai and over 100X in 14 other provinces, to 12% in Shanghai. However, it does not fully equalize expenditures and there remains a significant disparity in per capita expenditures, with higher income provinces spending signifi- cantly more. The fiscal expenditure differentials can be expected to increase as a result of the provincial contracting system. Under this system, better off provinces retain more revenues, generated by their growing tax base, while poorer provinces will not benefit from growth in transfers from an increas- ingly constrained and revenue-poor central government. 3.76 Tax Effort. An analysis of the level and growth of collections across provinces shows that, on average, tax collections are higher in Prov- inces where income is higher (Appendix Table 5). This finding stops short, however, of indicating whether higher income provinces also make a greater tax effort, i.e., whether they raise more or less revenue than might be expected given their economic base, level of urbanization, etc. For example, of the ten provinces with the highest levels of per capita output, six had below average revenue growth during this period. Conversely, of the ten provinces with the lowest level of per capita output, nine had above average growth in revenue collections. For policy purposes, the Chinese government wants to know not only which provinces have a greater capacity to finance, but how extensively they use this capacity. Otherwise, there is the risk of subna- tional governments using increased "central" resources to substitute for what otherwise would have been increased local government revenue mobilization.  -. 96 - 3.77 The ratio of collection to gross output is one measure of collection effort. This ranges from 18% in Shanghai to 5.4% in Shandong. In a province as poor as Gansu, it is to 9.82 (see- Table 3.6). Much of this variation is to the expected, because of differences in these provinces' taxable capacity. Hence this result cannot be used to infer that higher income Shanghai exerts more than twice the revenue effort as does lower income Gansu. In fact, as is shown below, Gansu actually makes a greater collection effort thian Shanghai. The problem with straightforward comparisons of collection-output ratios to infer tax effort is that proper account is not taken of differences in taxable capacity. 3.78 If the taxable capacity of the province is a function ofE its income level and its degree of urbanization, the higher level of per capita income-- proxied here by, the per capita gross value of output--should imply a greater capacity to collect taxes. Urbanization may also contribute to taxable capacity because urban economic activities are more easily reached by the administrative system (they provide better "tax handles") than do rural activ- ities. 3.79 Using per capita income and urbanization as indicators, each prov- ince's taxable capacity has been estimated and is shown in Columrn 2 of Table 3.6.17/ For example, based on the average practice and its own level of per capita output and urbanization, we woulcd "expect" Beijing's collection ratio, or taxable capacity, to be 12.78% of output. 3.80 Tax effort is the extent to which a province uses this capacity, and may be measured as the ratio of the actual collection rate to estimated taxa- ble capacity. Thus Beijing's predicted tax capacity is 12.7Z of output (col- umn 2), but the province actually raised 15.22 (column 1). This shows above average tax effort--specifically an effort which is 19% above average as is shown by the "tax effort index" (column 3). Shanghai, by contrast, in spite of its large absolute volume of actual collections makes only an average tax effort. 3.81 The ranking of provinces making stronger and weaker revenue collec- tion efforts reflects interesting factors. In general, many of the higher income provinces make a lower level of revenue effort, e.g., Jiangsu, Zhejiang, Shandong and Liaoning all make below average efforts and Shanghai is just about average. Therefore, the system the Central Government has designed to "encourage" revenue collection does not appear to be effective in encourag- ing those provinces where taxable capacity is highest to make the greatest effort. In fact, richer provinces are not always associated even with more rapid budgetary revenue growth. Box 3.3 discusses tax effort in an interna- tional context. 17/ The method usE!d here follows the approach developed in Roy Bahl "A Regression Approach to Taxable Capacity"; see 1970 IMF Staff Papers. Equation 5 of Table 3.5 shows the relevant coefficients. Tax capacity is positively related to per capita income (B1=1.54) and to urbanization B2=.0002.  - 97 - Table 3.8: COMPARISONS OF TAXABLE CAPACITY AND TAX EFFORT: BY PROVINCE Estimated Ratio of Collec- Taxable Tax Tax tion to Gross Capacity Effort Effort Province Output, 1986 1986 Index la Ranking Beijing 15.24 12.78 1.19 5 Tianjin 14.42 13.30 1.08 8 Hebei 7.52 8.00 0.94 15 Shanxi 8.93 8.48 1.05 9 Inner Mongolia 7.87 7.92 0.99 13 Liaoning 9.75 10.57 0.92 1S Jilin 7.75 9.09 0.85 18 Heilongjiang 7.82 9.09 0.88 17 Shanghai 18.06 17.96 1.01 11 Jiangsu 8.30 9.49 0.68 19 Zhejijng 7.93 9.18 0.86 17 Anhui 8.49 7.55 0.86 17 Fujian 9.35 8.05 1.18 8 Jiangxi 7.10 7.69 0.94 15 Shandong 5.44 8.70 0.63 20 Henan 7.46 7.42 1.00 12 Hubei 7.63 8.49 0.90 16 Hunan 8.06 7.73 1.04 10 Guangdong 8.61 8.33 1.02 11 Guangxi 8.90 7.43 1.20 4 Sichuan 7.18 7.62 0.98 14 Guizhou 8.79 7.18 1.23 3 Yunnan 12.35 7.28 1.70 1 Tibet 6.02 8.97 0.86 17 Shaanxi 7.86 7.84 1.00 12 Gansu 9.88 7.76 1.27 2 Quinhai 7.85 7.89 1.02 11 Ningxia 8.61 7.74 1.11 7 Xinjiang 8.25 8.14 7.88 -- /a Ratio of Tax capacity to actual collections. Other Problems and Issues 3.82 The economic reform program will bring important changes to the role of the subnational government sector in China. First, with more enterprise autonomy in management decisions and responsibility for financing their own operations, the provinces and local governments will shift emphasis from directly productive investments to general infrastructure development. Second, as enterprises become more independent in their management and record keeping, and as smaller enterprises and collectives grow in number, there will be a need to increase the efficiency of the tax administration system. Third, as markets become integrated, provincial and local governments eventually may find themselves competing for enterprise activity, possibly on a basis of public service levels and effective tax rates. Finally, local governments may look to the retained earnings of enterprises as a new source of infrastructure capital financing; over time this could lead to use of more formal benefit charges and borrowing relative to general taxation.  - 98 - Box 3.3: REVENUE SHARING AND TAX EFFORT The effect which revenue sharing has on the, tax effort of recipient pirovinces is an important concern. For example, if transfers from the central government cause the provinces' own tax collection efforts to decline, little has been gained in terms of increased support for expenditure programs. It is important, therefore, that revenue sharing consider tax effort, at least implicitly, in determining allocations among provinces. China's system does so via its emphasis on wresponsibility" and the incentives provided through the incremental retention schemes. The effectiveness of this approach is difficult to judge. Generally speaking, the first step in assessing 'tax effort' is to measure "taxable capacity.' Tax capacity, intui- tively, is determinecd by such factors as the level of income, the presence of easily taxed activities, the degree of urbanization, and so on. An estimate of taxable capacity can be made in China, by estimating the potential tax base of each province, and then applying an average tax rate to this potential base.1/ Tax effort is measured by comparing the actual taxes collected in a province to the estimat,sof it's taxable capacity. Why are these questions important in China? In the first place, one of the explicit objectives of the Chinese revenue-sharing syistem is to encourage the provinces' own tax I efforts; and, indeed, the central government has made substantial revenue concessions to the provinces to stimulate tax effort. In the absence of some estimation along the lines just described, it is difficult to know whether these measures are having the desiredl effect, or whether some poorer provinces may need additional transfers, because even a major tax effort (in relation to a small base) generates insufficient revenues. In India,, tax effort is used as one element of the formula for revenue equalization. In West Germany and Canada, tax capacity and tax effort have long been used as integral parts of the revenue equalization formulas. In Germany, for example, the average tax capacity of all states taken together is used as a yardstick of the minimum expenditures which the central government would like to be carried out in each state. The difference between this average per capita tax capacity and a province's actual tax capacity is calculated, and the difference (which may be either positive or negative) is paid into an "equalization fund' by the surplus provinces, or withdrawn from this fund by the deficit provinces. The German system, like the Chinese system, therefore, transfers resources from surplus provinces to deficit provinces. Whereas, in most countries, transfers are made from the central government, in Germany there is a settlement between the provinces, and in Germany, the amount transferred by more prosperous provinces is exactly equal to the amount transferred to deficit provinces. The German approach makes less-than-average tax effort costly, because tax sharing is based on estimates of the province's tax capacity. Thus, any province where tax effort is not commensurate with tax capacity will not be compensated for this below-averagis effort. In China, the revenue-sharing system, in all three of its variants, is designed to give incentives to the provinces to increase their tax collection. The sharing system in place in the majority of provinces, and the fixed quota delivery systems accomplish this by giving certain provirices a proportional share in all additional revenues that they collect. In the 'responsibility' system, the province retains 100% of incremental revenues collected over a certain quota. Likewise, in both variants of the "minority budget' system, provinces retain 100% of any revenue collected, transferring nothing to the central government. Strictly speaking, however, the incentive is being given for increased tax collec- tion, not tax effort. There is no way of knowing, in the absence of estimates of taxable capacity, how a province's collection relates to its taxable capacity. Thus, increases in tax collections may result from rapid increases in the tax base, while tax effort in relation to this base in fact declines. Under the current system of collection, the central government relies heavily on the tax effort of local governments. If the central government moves to collect its own taxes in the future, its reliance on the tax efforts of lower-level governments would of course be reduced. However, in the interest of balanced revenue growth, and to insure that; the prov- inces' own collection efforts are not negatively affected, China may want to incorporate tax effort criteria into the revenue-sharing formula. One alternative would be a bonus paid to those provinces whose tax effort increased relative to changes in the average tax effort of all provinces. 1/ The average or weffectivew tax rate is defined as the revenue raised from a given tax in all provinces, as a percentage of the tax base across all provinces.  _ 99 - 3.83 How well equipped are provinces and local governments to handle this new role and to take advantage of these new opportunities? What problems must they overcome in order to fully support the system reform? The answer, partly, is that there are some difficult problems to be resolved: a revenue base that may not be growing adequately, a system of implicit prices that compromises some of the objectives of a "good' system, weaknesses in tax administration, encouragement of informal approaches to local government fis- cal autonomy, and inadequate fiscal accounting and planning. 3.84 The present fiscal structure may not give provincial or other levels of government an adequate revenue flow to meet their expenditure requirements. Because there is no forecast or projection of expenditure needs, nor a clear statement of expenditure responsibilities of respective levels of government, the target income elasticity for expenditures is taken to be unity. The pres- ent system may not meet this target, though data limitations prohibit us from drawing a firm conclusion here. A number of pieces of evidence of revenue inadequacy might be cited. A substantial backlog of infrastructure needs is believed to exist. Eliminating this backlog is a future problem, along with the budgetary pressures of large increases in urban population. The profits tax, an important overall revenue source and major source of financing for provincial and local governments, does not have an income elastic base (partly because of contracting--see Chapter I), is cyclically variable in yield, and is sensitive to central government decisions about pricing and wage policy. Moreover, the continuing shift of the economic structure towards collectives and household firms expands the profits tax base to include activities taxable at a lower rate and harder-to-tax activities. The turnover tax may be more income elastic and more stable than the profits tax in the long run but, again, only a portion of its revenues accrue to subnational governments. 3.85 To answer this set of problems concerning revenue adequacy, the elas- ticity of the tax base will have to be increased. The best route for such improvement may be tax simplification so that compliance and monitoring are easier (as outlined further in Chapter IV) and strengthening administrative procedures and staff skills. An increase in the elasticity of the tax system, achieved by taxing the growing surpluses in the household and other sectors (as suggested in Chapters I and II), does not conflict with government objec- tives of increasing the financial strength or efficient performance of enter- prises. 3.86 A second set of problems has to do with the structure of the provin- cial and local financing system and the incentives such tax sharing may pro- vide for undesirable behavior by local governments. First, a potentially important problem area, where local governments may not be stimulated to maxi- mum efficiency, is tax administration. The incentives for avoiding full tax payment may be substantial: tax rates are high and the overall tax share retained through sharing or incremental quota arrangements by the municipality can be low. This alone suggests that local governments benefit little from higher collections and may not make a full effort. In addition, a principal component of the tax base is the sales and profits of municipally owned enter- prises. The local government would prefer to see such enterprises flourish, (and if necessary levy ad hoc charges which may be fully retained) rather than subject them to a shared tax.  - 100 - 3.87 PossibLy more important are the efficiency costs associated with not giving local governments some degree of autonomy. The governance system is decentralized in terms of the administration of public services, but formal local fiscal autonomy is limited. Legal tax rates do not vary significantly among communities or even within urban areas (although specific enterprises may be able to reach agreement on a preferential treatment). If diversity in tax rates is not: allowed, the goal of making local officials more accountable for their actions and thereby improving the efficiency of the delivery of local public services becomes very difficult to achieve. Moreover, interre- gional tax rates reflecting location rents and/or the costs of urbanization will not be developed and the tax system will not contribute to improving the spatial distribution of economic activity. The uniformity of the tax/subsidy system and the absence of a land tax probably promote a concentration of eco- nomic activity in the urban core (versus the outlying areas) as well as an inefficient use of land. 3.88 Finally, provincial and local officials will react to the absence of formal autonomy by taking 'back-door" approaches (negotiating, bargaining, 'experimenting") which may have effects that run counter to the goals of gov- ernment policy (as discussed in Chapter I). The development of the system of tax administration and central-local relations since 1983 has given provincial and local governments just such freedom to shape the fiscal systemn to meet their own objectives. If a tax rate on an enterprise seems onerous, it may be lowered by a contract negotiated with local authorities; if an enterprise is to be encouraged, it may receive special tax treatment; if a local. government is mobilizing increased resources, its retention rate might be lowered; and "favored" provinces may be more able to negotiate a special rate with the central government. 3.89 These back-door approaches destroy the concept of a fiscal system because they break the link between structure and implementation. The tax "levers" that the central government designs may be vastly different from the fiscal measures that are actually implemented at the local level. And even were it not for these "back door measures,n the administrative system may not be sophisticated enough to enable this "fine tuning" to achieve the desired objectives. These "levers" are wasted by an assessment and collection system that has not yet caught up, and by offsetting actions of provincial and local governments. 3.90 Another general concern--reflected throughout the report--is tax administration. There are incentives and opportunities for provincial and local governments to assist enterprise!s in tax avoidance. Moreover, the sys- tem is complicated and difficult to acminister, it requires a highly qualified staff for efficient administration, and books of account for smaller firms may be inadequate to the task of determining sales and profits tax activity. This problem will grow as smaller collectives and private businesses become more important. 3.91 In addition, there are problems with the way in which provincial and local governments marshal financial information to plan and control their fiscal activities. It is not possible to construct a unified budget of local government finances or of total capital expenditures in the urban areas, or to  - 101 - net out transfers between the municipal government and the enterprises or even between the provincial and municipal government. There is no multiyear bud- getary forecasting and no capital budget. In general, the budget does not appear to be used for planning purposes. 3.92 A more general problem seems to be growing up with the reform. With the switch from direct controls to "levers," there may be a tendency to try and do too much with the tax and transfer system. Example of some of its incentives include: (a) the phasing out of the adjustment tax depends in part on the amount of capital investment a firm makes; (b) property tax is deducti- ble from adjustment tax; (c) the construction tax rate varies by type of con- struction, e.g., plant expansion versus new plant; (d) there are more than 60 sales tax rates; (e) there are many ad hoc tax exemptions and "experimental' treatments, e.g., wage tax bonus is sometimes treated as a business cost; and (f) in some provinces there is a different local-provincial sharing formula for each tax, e.g., the distribution of taxes among the central government and the provincial, municipal and subdistrict governments in Zhejiang requires the application of 12 different formulae. It is not clear that the tax system can achieve all these goals. D. Options for Reform 3.93 The first step in a reform program is for the government to decide on the role it wants to assign the provincial and local government sector. In particular, the questions are whether provincial, municipal and county govern- ments will be given some degree of revenue-raising autonomy, whether tax administration can remain a local government responsibility, and whether the intergovernmental transfer system will include a formula-based grant program. 3.94 The choice of a particular central-local fiscal relationship will depend on how the government weighs the benefits of decentralized economic development policies against the costs of having less effective central fiscal management. There are strong forces justifying more fiscal centralization in China at the present time. Inflation and a budget deficit suggest a need for more central control over the budget for stabilization policy purposes. More- over, the economic system reform relies heavily on the use of tax policy as an instrument to influence economic decisions, and local control over the imple- mentation of the tax system can (and probably has) compromised some of the objectives of central government tax policy. In order to gain more central control over the revenue system, it will be necessary to reduce if not elimi- nate the provincial and local government power to allow contracting of types involving tax remission or special tax concessions. 3.95 To centralize the fiscal system, however, sacrifices possibilities of vesting more budgetary decision-making powers in local governments and to reduce the revenue-raising incentives of provincial and local governments, which are goals of system reform. Fiscal centralization vs. fiscal decentral- ization is a hard choice and each has benefits that the government does not want to sacrifice. Yet, one cannot have it both ways.  - 102 - 3.96 If the dlecision is in favor of increased fiscal decentralization in China, then three possible models can be developed; each with differing impli- cations for administration, and the extent and nature of the autonomy given to provinces. Limited Tax Shar:jL 3.97 This approach would call for separate central and provincial taxing powers, and the abolition of the shared tax system. The two questions to resolve would be which taxes to give to each level of government and what to do about tax administration. At one extreme is a very centralized approach under which the enterprise income tax and the product, business, and value added taxes wouldl become fixed central revenues. Provincial governments would be given the minor taxes (e.g., the 13 "fixed local taxes' assigned to them in 1988). There would have to be separate central and subnational tax adminis- trations because it would not be reasonable to expect that local governments would aggressively collect central taxes when they would not receive a share (see Box 4.5 in Chapter IV). 3.98 If this solution were adopted, provincial and local governments would be unable to finance all services for which they are now responsible, and one of two courses of action would be called for. One possibility would be for the central government to assume direct responsibility for provision of cer- tain services. This is not an attractive option because one tenet of the system reform is increased decentralization, and because China is simply too large and diverse! a country for a centralized public expenditure system to be managed efficiently. A more likely solution is to create a regu]Lar program of central grants to provincial governments to make up for the revenue shortfall. The grant could ble distributed on a formula basis, with the elements of the formula chosen to reflect need. For example, the grant distribution among provinces might be based on some combination of per capita income level, popu- lation size, some! indicator of infrastructure needs, urbanization, etc. Prov- inces would then develop their own formulas for allocations among the local governments (see Box 3.1 on Formula Grants). 3.99 The very great advantage of the centralized version of the local autonomy approach is that it enables a maxirmum of central control over inter- regional equalization and the sectoral composition of investment. It also puts the government in a better position to use the tax system for macrostabi- lization goals, and, because it merges responsibility for tax structure and tax administration, it makes possible the use of the tax system to achieve allocative goals. The latter point is especially important: the tax "levers" that the central government designed would be implemented. The biggest disad- vantages to this approach are the loss of provincial and local control over the tax system, the reduced incentive for revenue mobilization by local gov- ernments, and the increased expense associated with two separate tax adminis- tration machineries and with the maintenance and operation of a grant system. This centralized approach has been adopted by most low income countries that have unitary forms of government.  - 103 - Balanced Tax Sharing 3.100 There is also a more decentralized, or balanced version of the sepa- ration of powers approach. The subnational governments could be given access to one of the productive tax bases--namely control over the sales tax 18/ or the profits tax. Revenues could be large enough, at least for the highest income provinces, that a supplementary national grant scheme would not be necessary. Under this solution, provincial governments would have a considerable amount of discretion in determining the level of revenues and expenditures, and "the size of government" in the local area. When policy analysts and economists speak about fiscal decentralization, this is the version they usually have in mind. 3.101 The assignment of broad provincial and local taxing powers works in the United States and in the developing world, in Brazil, Colombia and Nigeria, in which between 25Z and 50X of all taxes are local. There are rea- sons why it also could work in China. Chinese local governments have broad expenditure responsibilities and this would make the revenue raising authority commensurate. Certainly local governments now have as much skill as the Cen- ter in administering a broad-based consumption or income tax. 3.102 There are also problems with this solution. Consider the problem of which of the two major taxes to choose. The profits tax would be a good choice because it is revenue productive, but it is also cyclically unstable and can be effected dramatically by central government policies, e.g., price changes for raw materials, a new wage policy, quota reductions, alteration in foreign trade policy. The sales tax would be more stable, but it is unlikely that the central government would agree to give up so productive a revenue source. The recently introduced urban land tax is a natural choice for a local government revenue source, but its revenue yield is unlikely to be sig- nificant. Another problem is that if the profit or sales tax were to be assigned to local government, then the two taxes would almost certainly have to be administered by separate central and local government tax administra- tions. This would be inefficient because book audits would be duplicated, enterprises would have to double their reporting requirements, and economies of scale in tax administration training and computerization would be lost. Finally, such a program would be counterequalizing in that the highest income provinces would generate the greatest amounts of revenue and a program of compensating grants would have to be developed. Base-Sharing Model 3.103 A third model might be sharing of the tax base, not the tax revenues. This arrangement would have subnational and central governments share in the base of the enterprise income and product, business, and value-added taxes. This would differ from the present system in two important ways. First, the central government tax would be fixed and totally independent of the local tax, and second, provincial governments would be permitted to elect (within a 18/ Note that if the VAT were made into a provincial tax, allowing differential rather than uniform rates in all provinces, raises special administrative problems.  - 104 - range) a surtax rate on each base. For example, a basic rate (say 20%) on the enterprise income! tax would belong to the central government as fixed revenue, and the provincial government could ielect an additional rate of 10Z (minimum) or 20Z (maximum).19/ For indirect taxes, the subnational rate might be an additional charge! levied as a percentage of the central government product tax liability, in much the same way as the present urban construction and mainte- nance tax is levied. In fact, the UCMT offers some precedent for this approach, except that the present 7Z, 5% and 1% surtax rates are fixed by the Center rather than chosen by lower level governments. 3.104 In the! case of turnover taxes the addition of a local surcharge poses few conceptual or practical difficulties provided the bases for t:he two taxes are indeed the same (i.e. if the surcharge is truly a surcharge). An invoice- based VAT could raise some difficulties under this approach. One problem is that provinces specializing in internediate goods would almost certainly prefer to "export" taxes to other provinces rather than zero-rate their own "exports". A true destination VAT would require some kind of adjustment for taxes on "imported" goods, as will now be the case in EEC countries. However it is doubtful local (provincial) governments would wish to give credit for "foreign" taxes on inputs suffered oni purchases from suppliers in other prov- inces. In Brazil, for example, the VJAT is a provincial tax, but the federal government sets mraximum rates.20/ While the experience of VAT haLrmonization in European Community offers some parallels here,21/ it appears unlikely a regionally rate-differentiated VAT could operate satisfactorily in China with- out central control. 3.105 Would revenues be adequate to meet provincial and local government expenditure needs under such a program? If the surtax limits were set to reflect expenditure needs, the higher income provinces could gene!rate adequate revenues but the lower income provinces could not. Two kinds of compensating formula grant programs would be required. One is an equalizing program to reflect the low fiscal capacity of some provinces. This is really no differ- ent in principle from the present system whiLch supplements tax sharing with transfers to deficit provinces. The other needed grant program would be to stimulate expenditures on projects with national significance, arLd all prov- inces would participate. 3.106 Local revenue administration might be retained under a base-sharing program, but provincial and local governments would not be permitted to engage in any tax relief policies that would affect, the base or rate of the central government tax. If provincial governments chose to contract with enterprises 19/ In practice, the exact rates wouLd be worked out based on the division of expenditure responsibility between the central and local governmLents. In the case of the VAT, this could mean that VAT sur- rates, if surcharges were permitited, would have to be identical across provinces. 20/ See Ved Gandhi; 'Tax Assignment and Revenue Sharing in Brazil, India, Malaysia and Nigeria', in C. McLure, ed. Tax Assignment in Federal Countries; ANU Press, 1983. 21/ See Tait, Alan, VAT: International Experiences and Problems; 1986.  - 105 - or provide tax preferences at the cost of reducing their own tax base, they could do so; hence the decentralization advantages would not be lost and some degree of responsibility would be built into the system. They could not, however, give preferential treatment on the central government tax. The sys- tem is described with an example in Box 3.4. Compared to the limited tax sharing and balanced tax sharing models discussed above, this approach implies less central governance and management of the tax revenue base and considera- bly more fiscal self-determination. Box 3.4: PROFIT AND SALES TAX SHARING UNDER A BASE-SHARING MODEL The simple numerical example here describes one version of how an enterprise would be treated under such a system. We have assumed fixed central sales and profits tax rates of 10% and 20%, respectively, and to make matters simple have assumed that the tax bases are gross sales and gross profits, respectively. In case A, the provincial government chooses rates of 5% and 16%, with no preferential treatments, with the result that it collects Y 950 from this enterprise by comparison with Y 1,600 for the Central Government. Case A Case B Gross Sales 10,000 10 000 Central Sales Tax at 10% 1,000 1,000 A. Provincial Sales Tax at 6% 600 B. Provincial Sales Tax at 3% 300 Less Production Expenses equals 6,500 5,500 Gross Profits 3,000 3,000/a Central Profits Tax at 20% 800 600 A. Provincial Profit Tax at 15% 450 - B. Provincial Profit Tax at 10% - 320 Total Central Revenue 1,800 1i800 Total Local Revenue 950 620 Now let us assume that the provincial government offers a preferential treatment to this enterprise and limits the sales and profits tax rates to 3% and 10%, respectively. Cen- tral revenues could not be affected, Y 1,600 is still raised in Case B, but local revenues would be reduced to Y 820 because of the tax abatement. /a Note that sales tax relief would affect the definition of local government taxable prof- its, (since sales taxes are normally a deductible expense) but not central government taxable profits. 3.107 There are disadvantages to this shared base approach. Provinces with a stronger economic base would have an advantage and the supplementary grant program would have to be created and maintained. The local tax administration system would have to be carefully monitored by a better Management Information System (MIS) than presently exists, to ensure proper collection of the Cen- ter's tax share. Another disadvantage is that the central government would give up some control over the tax system and therefore would have less leeway in using tax policy to pursue stabilization and macroeconomic goals. 3.108 Despite the disadvantages, one might be able to make a good case that this is an appropriate approach for China. It provides fiscal decentraliza- tion and the option to continue to allow provincial governments to follow local industrial policy, if this were considered desirable, while allowing the central government to retain some control over the level of taxation and com- plete control over the definition of the tax base. This system would give the  - 106 - local governments a significant incentive to improve the efficiency of their tax administration and of their public service delivery system. It might also be argued that, by comparison with the present system, central government macroeconomic control would not be compromised markedly. Patching Up the Present System 3.109 The above are radical reforms calling for eliminating the existing tax sharing system, giving local governments some rate-setting autonomy, creating a grant system, and changing the nature of responsibility for tax administration. Another possibility is that the decentralization of the eco- nomic reform will have to go more slowly, ,and the first step should be to patch up the present system. The objective is to eliminate some of the most objectionable features of the present system while retaining its strengths. The areas where reform is most needed are: (i) changes in the system of central-provincial revenue sharing; (ii) rationalizing the system of provincial-local relations; (iii) bringing the implementation oiE central tax policy under control; (iv) improving the system of capital financing, and (v) modernizing the system of tax administration and financial rmanagement. 3.110 Central Provincial Relations. The following changes should be made in the system of central-provincial relations: (a) If thLe tax sharing system is to be retained at all, the sharing ratios should be determined on some objective basis rather than in an ad hoc way. The 1983 base year approach should be rep]'aced. If Zhejiang's retention rate, for example, is to be lower than Anhui's, the difference should be based on some objective indicators. The government may want to substitute a formula for the present negotia- ted and judgemental approach, to compensate for lower fiscal capacity or greater fiscal need, or to reward greater revenue mobilization. (b) The tax sharing ratios should be f'ixed for a number of years to pro- vide provincial governments with some certainty, and to discourage the central government from allowiLng the sharing ratio to become a subject of annual negotiation. One possibility would be to set up a "grants commission" along the lines of those in India and Australia, to study and recommend a fixed, 5--year program of revenue sharing. (c) The provincial and local governments should know the sharing ratio well before the beginning of the fiscal year, to ensure, better fiscal planning and so that any incentive effects might be realized. At present, such information is given to the provinces well into the fiscal year. Increased tax effort cannot be expected to result. (d) The present approach to grants to provincial governments should be rationalized, perhaps converted to a regular grant program with a known pattern of distribution--and coordinated with the shared tax system. 3.111 The objective of making subnational governments more responsible for their actions would be served by giving subnational governments some taxing  - 107 - powers, though likely candidates for generating significant revenues are not apparent. Among the possible revenue sources for local governments, in addi- tion to the list of 13 approved in 1988, are agricultural taxes, the land tax or charge, and the dividends paid to local governments by state owned enter- prises for the use of assets. The latter were proposed in Chapter II as a way of separating the roles of government as owner and tax collector. While this would give local governments some independent revenue raising power, it would be far from adequate for covering the expenditure responsibilities undertaken by local government. 3.112 The central government must rationalize its delegation of powers to provincial governments, and the latters' control over local governments, with China's overall national development objectives. What is to be done when provincial policy runs counter to national objectives? The hard choice to be made here is between accepting this outcome as an unavoidable cost of decen- tralization and compromising the autonomy of provincial governments in con- trolling their fiscal structure. The view here, and perhaps the prevailing view in China, is that the enterprise contracting system is one area where the cost of decentralization has become too great and central regulation or limits are necessary. Another such area is the method of provincial-local tax shar- ing and whether this reinforces or offsets central fiscal objectives. 3.113 Provincial-Local Relations. Regardless of the local autonomy issue, the government should urge a reform in the system of provincial-local rela- tions. In particular, the present system of interprovincial revenue sharing is unduly complicated, perhaps inconsistent with national goals, and will present some major problems as system reform progresses. It can also be argued that the national revenue mobilization objectives are not well served by the provincial-local arrangements. Three changes might be considered. First, all taxes should be shared at a uniform rate. Second, provincial gov- ernments might consider increasing the municipal tax-sharing percentage for larger cities. If the retention rate were increased above its present level (usually less than one-third), an important incentive to improve administra- tion would be provided in exactly those cities where revenue-raising potential is greatest. However, this action would drain provincial government resources and could come at a cost of less fiscal equalization within the province. 3.114 More generally, provincial governments should rationalize the intra- provincial tax-sharing system. The sharing percentages should not vary across local governments in an ad hoc manner and the merits of a system of horizontal transfers--perhaps a capital grant system--should be considered. In any case, the distribution of grants and tax-sharing subsidies within provinces should be carefully, empirically studied to determine whether it measures up to the equalization and development goals of the Regional Economic Plan. This begs a bigger issue, namely whether the central government should play a direct role in the formulation of policy by provincial governments with respect to their local governments. Central governments in other large countries have done this when provincial policies became out of step with national goals (e.g., the United States, Brazil, and Nigeria) and China may be approaching a similar situation. However, this would be yet another step back from fiscal decen- tralization.  - 108 - 3.115 Local Discretion in Tax Administration. Perhaps the most important reform area is whether provincial and loca:L governments should have the authority to give special tax treatment to enterprises. Clearly, the objec- tive of giving the central governmenat more control over the tax system to better pursue stabilization policy and allocative goals would be served by eliminating or reducing local government d.Lscretion for giving tax concessions or tax remission contracts to enterprises. One option, argued in Section II above, is for the central government to limit such provincial arLd local gov- ernment discretionary power to contracting out of after tax profits. Another is the "balanced tax sharing" version of revenue sharing discussed above, which places responsibility for paying for tax preferences directly on the unit of government granting the preference. Either way, an evaluation of the options will come down to the question of how important it is for provinciall local governments to play a role in forming industrial policy. The central government must also put in place a central data system to monitor the effec- tiveness of local collection and assessment activities. 3.116 Capital Financing. There are good possibilities for mobilizing more resources for infrastructure finance. A formal mechanism for borrowing and benefit financing could permit local goverrLments to finance capital projects by tapping the willingness-to-pay of project beneficiaries. Likewise, a more formal and appropriately designed program of provincial government capital grants should replace the present ad hoc sy-stem. 3.117 Tax Administration and Financial M[anagement. Subnational budgets can be recast as more effective planning tools. The objective should be to regu- larly produce a unified local area budget, fully identify capital construction and maintenance spending and financing, and trace out all interaccount trans- fers. Multiyear budgetary forecasting and capital budgeting should be a regu- lar part of the planning process. T'he government needs to accept and act on the proposition that local governmerLt fiscal planning must be integrated with the long-term economic plan for an aLrea. 3.118 Potential improvements in tax administration are an important consid- eration. Without a full survey of administrative problems, it is difficult even to suggest the elements of a reform program. Among the possible needs, developed further in the next Chapter, are the introduction of taxpayer iden- tification numbers and a master file, more staff training, simplification of the tax structure itself, improved collections and assessment, and computeri- zation. An even more important underlying question is whether the tax admin- istration system should be more centralized and whether the administrative problems are as much related to the structure of the tax system as to its operation. Short of a thorough study of all these issues, it would seem ill- advised to consider the creation of a separate central and local government tax administration.  - 109 - IV. TAX ADMINISTRATION AND COLLECTION 4.1 This chapter discusses tax administration in China. Section A out- lines principles, criteria, and international best practice for the design and application of administratively feasible tax systems, including the structure of the administration, and its practices at the micro-level. Section B reviews China's current system of tax collection. Issues relating to current practice are outlined in Section C. The concluding Section D recommends reforms of national administration, current administrative hierarchy, and administration in provincial and local governments and outlines some near-term administrative reforms that would improve tax operation now. A. An International Perspective on Principles of Administration 4.2 The levying of taxes is a central function of government in all coun- tries and, while systems and methods vary widely according to the political, economic and social characteristics of individual countries, the requirements for a sound administration remain broadly the same. This is so whether one is concerned with the application of sophisticated corporate tax laws to multina- tional conglomerates or with the levying of bicycle taxes by local government. In the end, an administratively sound system of taxation is one that is: (i) simple and coherent so that taxpayers and tax administrators know where they stand; (ii) fair and seen to be fair; and (iii) efficient in that the right tax is collected at minimum cost to the state and to the taxpayer. The prin- ciples of simplicity, fairness and efficiency must be reflected in the design of the tax, its codification in law, and in its administration. 4.3 These characteristics are not ends in themselves but represent cri- teria for judging whether the administrative system will be able to meet the demands placed on it by tax design and by tax policy-makers. Ultimately, the payment of taxes depends on cooperation between the administration and the taxpaying community and, while few taxpayers ever volunteer to pay taxes, their willingness to comply will be enhanced if they have confidence in the system with which they have to deal. 4.4 Simplicity. International best practice outlines the importance of "simplicity' of the tax policy instrument, suggesting the advantages of reli- ance on key, broad taxes for revenue generation, the avoidance of 'nuisance taxes" and the need to prevent overburdening of any one tax (or the system as a whole) with too many objectives. Simplicity of codified law is also essen- tial if a tax code is to be implemented in the way that tax policy-makers intend. Good tax laws are both consistent and transparent so that a taxpayer entering into transactions can predict their tax consequences. Over-elaborate laws and regulations that are understood by no one will be obeyed by no one; worse, they will be resented and lead to a loss of confidence in the system. Therefore, while simplicity has, in the first instance, to do with tax policy, it has also important implications for administration. 4.5 Tax administrations need to provide clear information about the tax laws and how they are administered. Taxpayers need to be made aware of their rights and obligations and the consequences of their failing to meet them.  - 110 - They need to knoiw where to turn to f'or advice, how to make payments, how to reclaim tax overpaid. International experience has shown that it is possible to provide accessible information about even relatively complex provisions and systems. Authorities producing such material do so out of enlightened self- interest: A welL-informed taxpayer will facilitate the tax administration's own work and e:Efectiveness. 4.6 Fairness. International experience has shown that the willingness of taxpayers to cooperate (the "standard of compliance") is generally higher when tax laws are perceived to be just and fair. Taxes that are percieived to be fair are more likely to be paid. Fairness 'has several dimensions. It implies not only "vertical equity," so that tax lia'bilities are borne by those who can best afford them, but also "horizontal equity," in which taxpayers in the same or similar circumstances pay the same or similar taxes. Authorities need to encourage voluntary compliance, whether this be the compliance of the taxpayer himself or, in the case of taxes withheld from wages, collaboration from the employer acting as an unpaid agent for the tax authority, or compliance of the business collecting indirect tax on behalf of the tax administration. None- theless all tax laws include, or should include, penalties for taxpayers who evade or otherwise fail to comply with their responsibilities. 4.7 The objective of fairness can best be achieved if taxes are imposed and administered only in accordance with published and properly constituted laws. Most countries have found it desirab:Le to ensure that the right of authorities to inmpose a tax is enshrined in primary legislation passed by the country's highest law-making body. Although administrative procedures may be governed by lower-level legislation ("decrees", "orders" and "regulations"), it is generally accepted that explicit authority for such rules End procedures should be provided in primary legislation. Tax systems that depend on ad hoc administrative action rapidly become discredited and imperil compliance. But, if such rulings are given--and some experts would question whetheer they should be--there is a growing consensus that they rmust be made public. 4.8 To encourage compliance it is equally important that tax authorities administer the law fairly. This implies both an absence of arbitrary or cor- rupt behavior on the part of officiaLs, and "normative standards" to ensure that the same laws are applied and adiministered in standard fashion across the board. Indeed, a major responsibility of a national tax administration is to ensure that all taxpayers dealt with by a given official are accorded similar treatment and that all officials dea:Ling with a given taxpayer would accord the same treatment. Plainly, this task will be harder in a large! country with a highly decentralized organization than in a small country or within a com- pact headquarters office. 4.9 Finally, to enforce these "normative standards", taxpayers should, in the case of disputes with the authorities, have access to independent arbi- ters. Preferably, the process of appeal should be quick and inexpensive. In many systems, a "first appeal" against administrative decisions can be made to some higher-level authority at the regional or national level of the tax administration itself. However, it is usual for taxpayers ultimately to have  - 1ll - access to a truly independent forum. In some countries such as Mexico, the U.S., and West Germany, the law provides for specialized "tax courts". Efficiency in Administration 4.10 Why Efficiency Matters. The functions of tax administration are (i) the collection of taxes; (ii) the auditing of tax returns of enterprises and individuals; (iii) the recovery of tax underpayments; (iv) the investiga- tion of fraud; and (v) the enforcement of penalties in cases of evasion or default. The requirement of efficiency is, of course, not confined to the administration of taxation--it is common to all areas of government. But because the costs of collecting taxes go well beyond the surface cost of employing and equipping tax collectors, efficiency in tax administration is especially important. Such costs include also the "compliance costs" incurred by enterprises and individuals in carrying out their responsibilities under the law and the costs incurred by enterprises who are required to act as tax withholding agents for the authorities. In the U.S. it has been estimated 1/ that filing of a standard individual taxpayer's return can take some eight hours annually in terms of the taxpayer's "lost time" and in many cases com- pliance costs equal or exceed those incurred by the official tax authority administering the law.2/ The "economic cost" of taxes incurred by the diversion of goods and services from their optimal pattern of use in the com- munity was already described. Enforcing tax law at a minimum cost to the government means making use of modern office techniques and effective manage- ment. Keeping compliance costs low for taxpayers depends on the mix of taxes and the taxpayer's role in payment. The costs of collecting taxes on individ- uals are usually higher than those on corporations. For example, in 1987 the percentage cost (as a percent of revenues collected) of collecting United Kingdom corporation tax was 0.52Z, less than one-quarter of the cost of col- lecting income tax for individuals (2.29Z). In the U.S.A.--where collection costs are relatively low and self-compliance is high--all individual taxpayers are required to file a tax return each year and average costs are 0.49Z of revenues collected. 4.11 Effective Use of Administrative Resources. No tax administration ever has the financial resources it would ideally wish to have. Among its responsibilities of collection, audit, recovery, enforcement and control, some could be performed better or more promptly if more resources were available. This means that the administration must define its priority tasks, assess the resources that should be devoted to a particular task and determine how those resources may best be deployed to secure the optimal revenue yield. Often, this means that administrative resources (both staff and hardware/software) should be allocated where they will produce the highest marginal revenue. If, in a given country, experience shows that an extra $1 spent on audit will raise $10 in revenue, while the same $1 spent on pursuing delinquent accounts would raise only $3, then the presumption will be in favor of improving the authority's audit effort. 1/ Arthur D. Little, Inc., IRS Fact Sheet FS-88-5, 31 August 1988. 2/ See, for example, C.T. Sandford "Hidden Costs of Taxation", London: Institute for Fiscal Studies, July 1973.  - 112 - 4.12 Efficient resource allocation presupposes adequate management infor- mation to allow rational decisions to be taken and like most large organiza- tions, tax administrations depend heavily for their success on the quality of their management information systems (MIS). Such a system is designed to give managers at different levels information on which to base their decisions. In general, this information will be expressed in numerical (quantitative) terms but it may need to be supplemented by narrative reports from managers evaluat- ing and amplifying the statistical data supplied (qualitative reports). Such a MIS would not necessarily call for computerization but for adequate informa- tion and reporti:ng to the central tax authorities. 4.13 For greatest efficiency in collection, a choice has to be made between "assessed" and "self-assessed" taxes. Assessed taxes are those where a tax official undertakes the work of calculating the tax liability. Self- assessed taxes riequire the taxpayer himself to quantify his liability and pay the tax. Both types of assessment must be accompanied by effective audit programs. Sales taxes are almost always self-assessed. International prac- tice in relation to taxes on enterprise profits and incomes of individuals varies, but there is a clear trend towards self-assessment as countries seek to deploy scarce administrative resources in the most cost-effective way. Countries with stelf-assessment for corporations include Canada, Japan and the U.S. The same countries have also had self-assessed personal income taxes for many years. Hungary introduced the latter in 1988. By contrast, land taxes are almost always assessed. 4.14 With respect to actual payment of taxes, many countries use a with- holding system to ensure prompt payment. Withholding typically applies to payments of wages; and salaries, interest and dividends. In this system, the tax liability is the income recipient's, although tax is payable by the payer of that income, 4.15 Audit and Other Techniques for Ensuring Compliance. The basis for ensuring satisfactory compliance, whether taxes are "assessed" or "self- assessed," is a balanced audit program. Tax audits to be effective, should be selective and based on a system of stratified sampling that selects (i) taxpayers likely to have made significanat understatements of liability; and (ii) other cases likely to involve small amounts but representative of a cross-section of taxpayers where combined amounts will be signif:Lcant. Audit- ing the first group puts appropriate focus where revenue yield is likely to be high, while auditing the smaller taxpayers carries an important "deterrent" effect. Countries have adopted this selective approach primarily because auditing resources are limited; if every case were examined only superficial examination woulld be possible and few errors would be discovered. (See Box 4.1).  - 113 - Box 4.1: AUDIT PROGRAMS A typical selective audit program involves both 'desk audits' and 'field audits",, depending on whether the auditor carries out his work at his own desk or visits the taxpayer in the "field".; Desk audits can vary in their intensity but typically begin with a review by the a uditor of all the information he has about the taxpayer from various sources. Where the taxpayer is in business on his own account the auditor will usually invite him to attend the office and bring his business books and records for examination. Desk audits will be appro- priate in the case of employed individuals with part-time earnings and other secondary sources of income and in the case of larger enterprises where issues of tax law rather than the ade- quacy of record-keeping are at stake. In the case of a field audit, again the auditor will begin with a review of his information but will then foTiow this up with an on-site inspection of the taxpayer's premises and his business books and records. Generally, field audits will be made of the affairs of traders, farmers and other 'self-employed' people such as professionals where questions of fact can only be resolved by a physical inspection of trading premises, processes and primary records.S In some countries (for example, the United Kingdom and the United States, an audit is, at least initially, confined to the results of one year. In others, (for example, France and West Germany) it invariably covers a number of years, usually all previously unaudited years not excluded by the country's statute of limitations. In practice, this means that transactions of up to five or six years may be the subject of a single audit. In either type of audit, where shortcomings or irregularities are discovered the result of the exercise will almost always be an interview with the taxpayer at which the rea- sons for those shortcomings or irregularities will be discussed and any additional tax and/or penalties will be quantified. Audit coverage varies widely, but many countries try to audit every entity at least once within the peTrMiodf statutory limitations. It will be desirable to audit some enter- prises every year. This would apply, for example, to major financial or industrial enter- prises with complex commercial relationships, international connections and frequent changes in investments. Likewise, it will generally be desirable to audit newly-established busi- nesses and those where the proprietor is ceasing to trade or is transferring the trade to a successor. In other cases, where, for example, a trader in a mature business shows steadily increasing turnover and profits consistent with those in a similar line of trade, and in the absence of any other indication of irregularities, it might be felt that little would be obtained from going through the motions of an audit. A number of countries (Canada and the U.S.A. among them) have developed more or less sophisticated statistical models for selecting cases for investigation. Criteria include: gross and net profit ratios out of line with the norms for that business; abnormally low or abnormally high personal expenditure; the acquisition of luxury or expensive personal assets; failure to respond to routine correspondence; failure to claim reliefs or allowances to which i the taxpayer is entitled (these last two criteria may suggest that the taxpayer is avoiding contact with the tax authority). In some countries, computers are used to identify cases for possible investigation. Usually, however, computer selection is supplemented by the judgment of the head of the investigating office or unit who will review each case personally before an audit is authorized. Critical to the success of any audit program is the way in which it is managed. Besides the need to select the right cases for audit it is necessary to ensure that individual audits are proporly conducted in every respect and that the work of auditors is satisfactorily monitored. This calls for managers who themselves have experience in audit work and who have received adequate training. Audit program managers will usually accompany staff in a number of audits and observe at first hand how they are conducted. An important part of the cycle in some countries is the follow-u report which is designed to inform management of the effectiveness of the audit program. esi es statistical data, such reports should contain a qualitative evaluation which will indicate good or poor investigative technique, information and training needs and any data that would be of use in future audits. These reports would be part of a comprehensive MIS (see text, para. 4.12) In some countries (the USA and the United Kingdom among them) a percentage of all audits are 'inspected' to guarantee the proper conduct of investigations. The following table shows the audit rate achieved in a number of countries in recent years:  - 114 - Box 4.1: (cont'd) Box Table: INTERNATIONAL COMPARISONS OF AUDIT COVERAGE Country Tax Year Taxpayers Audit rate (% covorage) Barbados Income tax 1978 58,581 11.2 Fiji Income tax 1984 50,000 1.0 New Zealand Income tax 1988 1,029,000 1.8 VAT 1988 386,000 8.8 South Korea Corporate tax 1987 45,078 5.7 United Kingdom Corporation tait 1987 641,032 1.1 Income tax 1987 2,178,746 2.2 VAT 1988 1,505,000 28.0 USA Corporate taxesg 1986 3,858,937 2.2 Income tax 1986 184,176,609 1.1 4.16 Cost-efficiency concerns have also led a number of countries to adopt systems of "pres mptive" taxation for types of activity that are particularly difficult to tax. Perhaps the best-kinLown of these systems is the French "for- fait" system which applies to small farmers and, to a lesser exterLt, to some professionals as well. Presumptive methods rmay encourage economic: activity because any excess over the average will be taxed at zero marginal. rate. However, use of presumptive methods muist be exercised with care to avoid ine- quities that can. occur if the average tax rate borne by regular taLxpayers, such as wage-earners, exceeds that borne by t:hose subject to the presumptive method, Machinery of Government 4.17 Countries have adopted different approaches for locating the tax policy-making and tax administration functions within the government. In most countries the tax policy-making function is located within the Ministry of Finance. In others (including the United Kingdom and China) it is located in a semi-autonomous board or service, also responsible for tax administration and often operating under the political authority of the Ministry of Finance. This arrangement reflects the highly specialized nature of tax policy work and its close links with tax administration. However some control must be exer- cised to make sure tax policy developments are in line with macro-economic policies of the overall government. 4.18 A larger number of countries (the USA, Canada, Hungary among them) have established semi-autonomous agencies to handle tax administration. In each case political responsibility remains with the Ministry of Finance, but operational matters are the responsibility of the tax administration author- ity. In general, countries see two maLin sets of advantages in this separa- tion. First, the creation of a separate authority insulates the administra- tion of taxes from political pressures. This enhances the status of the  - 115 - administration by allowing it to be seen as independent of the politicians responsible for enacting tax legislation. 4.19 The separation also recognizes the fact that the function of tax administration is different from the rest of the largely policy-oriented work of the Ministry of Finance. Apart from the fact that tax administration is ultimately about individual cases, it also involves the employment of a large number of specialists whose background and training, career requirements, and perhaps even pay, may differ from those of regular Ministry officials. The Organization of the Tax Administration: Centralization vs Decentralization 4.20 Whether responsibility for tax administration is retained exclusively by the central Finance Ministry (as it often is), or delegated to provincial governments (as in West Germany) or to a semi-autonomous board (as Hungary), its organization will depend on a series of factors unique to each country. Whatever the institutional arrangement, it is essential that tax administra- tors have easy access to taxpayers and vice versa. 4.21 In most systems there is a clear division of responsibilities between offices at different levels of the hierarchy. Headquarters staff set and interpret policy and lay down standards for operational offices, including procedures for collection, tax return filing, audits, enforcement and litiga- tion. Regional staff are responsible for monitoring the performance of local operational offices, for dealing with complaints, personnel matters and for ensuring that norms set by Headquarters are applied. Operational staff handle actual cases, issue, receive and process tax returns, carry out audits and pursue delinquent taxpayers. Taxpayers turn to these offices in the first instance for information and assistance. B. Tax Administration and Collection in China The Institutional Background 4.22 In China, the imposition and levying of taxes on enterprises and individuals is the responsibility of bodies at various levels of government. At the national level, there are the Ministry of Finance (MOF) and the State Administration for Taxation (SAT). At the subnational level, the provincial and lower-level city and county governments each have their own Tax Bureau and Finance Bureau. The roles and relationships of these various bodies are des- cribed in greater detail in Annex 3. 4.23 While the central government in China deals with tax policy, it does not, in general, collect tax revenues. Unlike most other countries, the cen- tral government has no nationwide tax collection administration. Instead, provincial and county Tax Bureaus are responsible for the day-to-day work of assessment and collection throughout the country. The great bulk of tax col- lection takes place at the local level, with the central government relying on local governments for the implementation of central tax policy and for the remittance of tax revenues. Important exceptions are: customs duties, col- lected by the Customs Bureau; taxes relating to the extraction of China's  - 116 - offshore petroleun reserves handled by the Offshore Oil Taxation Bureau, for- merly within thie GTB and now within the SAT; and the tax affairs of certain large state enterprises such as the State railway companies, the state air- lines, the specialized banks, and the People's Insurance Company, whose income taxes are paid directly to the SAT. 4.24 National Level Organization. The Minister of Finance is personally responsible to thie nation's State Council for tax policies and for tax collec- tion. Within the Ministry of Finance, the General Taxation Bureau (GTB) has been responsible for tax policy and administration and for supervising the assessments and collections by local tax bureau officials employed by provin- cial and lower-level governments. Tco fulfill these responsibilities, the GTB had just 345 staff at end 1987, most of whom are new recruits.3J This reflects in part the turbulent history of tax administration in China, including the merging of Tax Bureaus with other organs of government and their suppression during the cultural revolution. 4.25 Following a major reorganization of MOF in mid 1988, the General Taxation Bureau (GTB) was taken out of MOF and its functions placed with the newly constituted State Administration for Taxation. SAT was established on June 1, 1988 and is a quasi-Ministry insofar as its head reports directly to the State Council, while acting "under the guidance" of the Minister of Finance. SAT has a degree of autonomy not previously enjoyed by GTB. The main tasks of SAT are listed in Box 4.2. Following this reorganization, there are no officials within MOF directly concerned with formulating current tax policy or with tax administration and collection. A small unit concerned with tax reform analysis remains. 4.26 Table 4.1 outlines the range of taxpaying entities in China for which the SAT is ultimately responsible. The 32 million, mostly business, taxpayers in China represents a large number by any international standard. The state- owned enterprises and collectives are charged with the use of public funds and assets and expected to keep detailed records. The work of auditing and asses- sing such enterprises requires staff with considerable training and experi- ence. The township enterprises and individual/household businesses represent the rapidly expanding "private sector" of the economy. In such cases the tax authorities can expect to rely on alternative techniques, including the use of estimates of turnover and profitability, to establish liabilities. In addi- tion, the volatility of this sector imposes a heavy administrative burden on the authorities in identifying, registering and monitoring potential taxpayers to ensure compliance and payment of tax. There are, in addition, insignifi- cant numbers of employed individuals paying personal income tax and personal income adjustment tax. 3/ At the end of 1976, the staff of the GTB consisted of only 36 persons.  - 117 - Box 4.2: TASKS AND RESPONSIBILITIES OF THE STATEIDMINISTRATION FOR TAXATION (SAT) La 1. Major Responsibilities of the SAT: - implementation of the taxation objectives of the State Council; - administration of national taxes; - tax policy; - the drafting of national tax laws; - the drafting and issue of administrative regulations; - the collection of (national) tax revenues; - the use of taxation as a macroeconomic lever; - the management of tax cadres within provincial governments; - training and coordination within the tax system; - negotiation with foreign governments and representation of China in interna- tional bodies; and - administration of taxation on offshore oil reserves 2. The National Taxes for Which the SAT is Responsible (a) Turnover taxes Product tax VAT Business tax (b) Income taxes . on SOEs on collectives on individual and household enterprises personal income tax personal income adjustments tax (c) Resource taxes (d) Special-purpose taxes: construction tax bonus tax fuel consumption tax vehicle tax real estates tax slaughter tax salt tax (e) Taxes on foreign-owned enterprises /a This is not an exhaustive or official list of SAT responsibilities. Table 4.1: CHINA: TAX-PAYING ENTITIES BY TYPE OF TAXPAYER - 1988 Type of Entity Millions State-Owned Enterprises 0.4 Collective enterprises 1.6 Township enterprises 16.0 Individual/household businesses 16.0 Total Taxpayers 32.0 Source: SAT. 4.27 Provincial Governments: Organization and Functions. Immediately below the central government stand the governments of 26 provinces and autono- mous regions and three cities with the status of provinces, Beijing, Shanghai  - 118 - and Tianjin. All the governments at this level are referred to collectively in this chapter as "provincial governilments" or "provincial administrations". Each provincial government has a Tax Bureau with responsibility for overseeing the work of the lower level bureaus at the city and county level., 4.28 Provincial Tax Bureaus are organs of the provincial government whose directors report horizontally to the provincial Finance Bureau and hierarchic- ally to the SAT f'or implementing official tax policy and delivering tax reve- nue. These relationships are illustrated in Figure 4.1. In theory, the appointment of a provincial Tax Bureau director requires SAT approval. The tasks of a provirLcial Tax Bureau may be summarized as follows: define the tax law for its subordinate administrations; co:Llect the appropriate taxes; grant (within its authority) certain exemptions and relief; coordinate with related agencies; and supervise in turn lower-level governments. Eigure 4.1: THE HIERARCHY OF TAX AND FINANCE BUREAU State Council Ministry of Finance Provincial Government:s Finance Buireau ax Burea j - - Municipal and-_ County r Government1s 1 ax Bureau - _ _ _ __ Finance _l- Bureau Tax Branch/ Tax Branch/ Tax Station Tax Station 4.29 The regulations currently governing tax administration in China were issued in 1986 by the State Council, and empower provincial governments in turn to issue amplifying supplementary regulations. Provincial regulations  - 119 - cover the establishment of time limits for certain actions by taxpayers and assignment of responsibilities for tax administration to different levels. 4.30 Municipal and County Tax Bureaus and Offices. Below the provinces stand the cities and counties with 2,600 Tax Bureaus and some cities incorpo- rating a number of counties in addition to their own jurisdiction. These are the lowest level of government employing tax officials not only at city or county headquarter offices but also at smaller suboffices. Suboffices of city governments are known as "branches" numbering 1,800; sub-offices of county bureaus are known as "tax stations" numbering 25,300. Over 240,000 persons, more than 60Z of all staff engaged in tax administration, work in these "tax stations". The remainder largely work in the "branches". A small minority is therefore engaged in supervisory activities at the provincial level or at the SAT. 4.31 At both provincial and municipal/county level, Tax Bureaus are matched by Finance Bureaus, whose task it is to draw up and administer the provincial or municipal budget and handle the jurisdiction's financial rela- tions with superior and subordinate governments. Finance Bureaus formally represent the government as "owners" of the jurisdiction's SOEs. In addition to being responsible for "industrial policy", they have a strong interest in the granting of preferential tax reliefs for enterprises in their jurisdic- tion. Within the provincial hierarchy, the Tax Bureau is a relatively junior department and its director has a lower status than his counterpart in the Finance Bureau, equivalent to the latter's deputy and therefore carrying less weight. At the municipal level, the Tax Bureau and Finance Bureau have equal status. 4.32 In the pre-reform period, the Finance Bureaus were responsible for the entire range of regulation of local enterprises, including profit remit- tance. With the move away from profit remittance, however, formal responsi- bility for enterprise taxation has passed to the Tax Bureaus. Nonetheless, in some cases, and contrary to official regulations, taxes paid by SOEs continue to be credited to the accounts of Finance Bureaus instead of to those of Tax Bureaus. All in all, there is tension between "industrial policy" and stan- dardized tax administration. Some Tax Bureaus, for example, do not collect data on SOE profit taxes to finance bureaus. This runs counter to the concept of integrated budgeting and undermines the functional responsibility of the Tax Bureaus. 4.33 A decentralized system will generally involve a three-tier hierarchy of administration--headquarters, regional office, and local offices. From the point of view of management control, this structure enables managers at the regional level to be close enough to the work of local offices to be fully conversant with local conditions. It also means that such regional managers can have realistic "spans of command" in that only a reasonable number of local officials report directly to them. A clean division of responsibilities between offices at different levels is needed. In China, however, it is not clear that higher level offices have adequate controls over lower level units.  - 120 - Tax Collection Machinery and Practice in Chi-na 4.34 With respect to methods of tax collection, China has an extreme form of the "assessment" system, even with regard to the Business, Product and Value-added taxes. Enterprises assume little or no responsibility for comput- ing their own profits or indirect tax liabilities and virtually all the work of calculating net income, determining applicable tax rates and establishing tax liabilities is done by Tax Bureau officials. No manuals or publications are available for guiding taxpayers. This practice effectively allows taxpay- ers to abdicate responsibility for paying the correct amount of tax. 4.35 Moreover, China is exceptional in relying on tax officials, resident in large enterprises, to administer the tax law. These resident tax officials assist it in assessing the tax consequences of enterprise transactions and advise on potential tax incentives available to the enterprise. Any claim for tax incentives must be accompanied by a recommendation from the resident tax official. These are in an ambiguous position. On the one hand aL resident official is supposed to review the enterprise's tax liabilities in an objec- tive way. On the other hand, as an on-the-spot representative of the owner of the enterprise, he is supposed to look for ways the tax system catn be operated in favor of the enterprise. A possible outcome, given the "dual leadership" of the Tax Bureau is that the latter duty supplants the former arLd objectivity is lost. 4.36 With respect to methods of tax payrnent, enterprises pay direct tax and indirect taxes assessed by the Tax Bureau inspector to the erLterprise' s bank. This is dcone in a cumbersome way, specifically, payment vouchers are six-part forms. China has adopted the system of withholding taxes (PIT and PIAT) for some wage and salary paymenits. W:ithholding is also used for pay- ments of dividend[s and other passive income,, such as interest, royalties and rent, made to foreign enterprises. However the growing number of double taxa- tion treaties signed by China reduces the impact on foreign investors. 4.37 The audit system in China inivolves reviewing all tax returns each year, plus a second in-depth review of a large sample of cases. Because this extensive review cannot be at the same time very intensive, in ge!neral, only cursory (e.g. arithmetric) checking is generally possible. Resources cur- rently employed cn 'front-end' tasks of calculating income and tax, described in paras. 4.34 - 4.35, could be more effectively used in carrying out "back- end" auditing, concentrating on areas where the revenue yield is most at risk. 4.38 Additional tax collected as a resu:Lt of the enforcement efforts of the various tax bureaus in China seems disproportionately small. An estimated Y 1.76 billion, or 0.6Z of total revenues, was recovered in 1987. This is particularly wcorrisome because the rratio of staff to taxpayers in China is high by international standards.  - 121 - C. Analysis and Issues How China's System Compares 4.39 Measured by the criteria of simplicity, fairness and efficiency, China's tax system, and its laws and administration, fall short in a number of respects. Many countries have systems that are less than perfect, but in a number of areas China's practice is far out of step with international best practice. 4.40 The most striking feature of the Chinese tax system is the multipli- city of taxes. There are 28 taxes (plus 2 levies) being administered by the SAT alone. (In addition, the agriculture tax and cultivated land occupancy tax are administered by Finance Bureaus). Leaving aside the dozen or so spe- cial taxes on specific transactions, resources or expenditures, the system is differentiated according to both economic sector (agriculture, commerce, industry) and form of ownership (state-owned, collective, household/individ- ual, Chinese, foreign). Consequently, an SOE engaged in textile manufacturing pays a different income tax and a different turnover tax than a collective enterprise engaged in wholesale textile distribution. This creates adminis- trative difficulties, apart from tax policy considerations. 4.41 The rate structure of many taxes, notably the turnover taxes, are highly complex. In most countries the taxpayer determines the appropriate rate for his particular activity from a published list. China's complex sys- tem requires requires that even this preliminary determination be done by the Tax Bureau. This multiplicity of rates is not only expensive to administer but is also prone to error as taxpayers and officials alike misinterpret and misapply the law.4/ The more complicated a system becomes the greater the probability that it will not be implemented as its designers intended. And, as noted, the SAT has no means to assess this. 4.42 On fairness, there are several factors in China that tend to under- mine the integrity and credibility of the system. The first is that only three of the 28 taxes administered by the SAT have the full status of laws passed by the People's Congress.5/ These three laws apply to foreigners who are accustomed to the certainty of properly constituted laws, although this is undermined by the large number of ad hoc local interpretations and deviations from the law that apply in practice. The rest have the status of decrees or are covered by "provisional" laws. 4.43 A second factor undermining the fairness of the system is the regional variation in tax administration. A third factor is the apparent absence of formal legal and appeals procedures, and, more importantly, the practice of the authorities of increasing previously settled tax liabilities if further amounts are deemed payable. In China taxpayers are generally 4/ The rationale behind the multiplicity of rates, its relation to equalization of profitability were each discussed in Chapter II. 5/ These are the Foreign Ventures Income Tax, the Joint Ventures Income Tax and the Individual Income Tax.  -- 122 - obliged to accept decisions by the t:ax authorities as final, although they may raise complaints to higher levels of government. The absence of a formal legal appeals process has the risk on the one hand of placing ad hoc power in the hands of individual officials. At the same time, the absence of legal and enforcement powers of SAT officials, which in most countries would be taken for granted (such as the right to examine bank accounts, and goods depots or vehicles) seriously weaken the administration. 4.44 At present, MOF and the SAT operate under a number of handicaps impeding greater efficiency in tax administration, the greatest being an almost total lack of data reporting that their counterparts in other countries would regard as indispensable. Financial dlata are available centrally on total tax collections and on expenditures through the compilation of Treasury accounts at PBC in the context of budget planning. However, there are no figures and no reporting available to SAT on collection costs, the effective- ness of audit work or any other functions of the tax administration and actions undertaken in local Tax Bureaus. I'his makes it virtually impossible for the SAT to gauge where incremental effcrts, such as withholding and audit- ing, should be deployed. 4.45 Tax collection costs in China may be excessive because of a large number of minor, nuisance taxes and inefficient procedures. Administrative and compliance cost of numerous minor taxes are considerable, and they are subject to wide discretion by tax collectors. Collection costs in modern tax systems will range between 0.5 and 2.5Z of total revenues; comparable figures for China are not known. 4.46 The description in Box 4.3 of the steps in turnover tax administra- tion indicates just how difficult it is for an enterprise to pay its tax and fulfill its other obligations towarcds the tax authorities. In particular, the enterprise is required to have frequent con,tacts with the Tax Bureau and numerous copies of forms (invoices, payment vouchers) are produced. PIT and PIAT are administered monthly, making taxpayers contact Tax Bureaus more often (the norm appears to be twelve times) than in most countries where a worker might expect to contact the tax office only once a year. Machinery of Government 4.47 China has followed a practi.ce adopted in many countries of placing responsibility for tax administration with a semi-autonomous authority. The decision to include in the SAT responsibility for tax policy carries with it the risk that, whatever the arrangements for coordination between MOF and the SAT, those responsible for tax policy and those responsible for other economic and budgetary policies will not coordinate their work. Centralized vs Decentralized Administration 4.48 Strengths of the Present Administratively Decentralized System. The devolution of responsibility for tax administration from the center to the lower-level governments carries with it a number of advantages: China is a very large country and communications are not good. Similarly, economic and social conditions vary enormously sO that matters important in one province  - 123 - Box 4.3: THE STEPS IN TURNOVER TAX ADMINISTRATION Step 1 The enterprise registers at the Commercial and Industrial Bureau and is given a registration number. The enterprise then takes the number and the completed regis- tration form to the Tax Bureau. Step 2 The enterprise completes a tax registration form at the Tax Bureau. A copy of this form is sent to the other tax offices and a certificate is issued to the firm. Step 3 With this license, the firm can purchase sales invoices (receipts). There is a very strict control of these documents. Each invoice bears a tax stamp impressed by the tax bureau, and they must be used with all transactions. Invoices can only be pur- chased on production of the license, but they can be printed outside with approval of the Tax Bureau. Each invoice consists of five copies. Step 4 The enterprise or resident advisor must fill in background information for turnover tax purposes. The enterprise headquarters fills in the form for whichever of the three taxes for which it is liable, calculates the kinds of tax rates that are applicable, and then returns the form to the tax bureau. The Tax Bureau headquar- ters then transfers information from this background sheet to another form which shows the approved rates, etc. that will be applicable to the enterprise. Step 5 The enterprise completes a declaration form when it is prepared to pay the tax. The form allows computation of sales tax, urban maintenance and construction tax, and the education surcharge. This declaration form is then brought to the Tax Bureau where the tax officer examines it and recalculates the tax amounts. The taxpayer makes out a six-part payment form. This must be done before the 7th of each month. Step 6 The enterprise takes the payment form to the bank, and the bank withdraws the money from the enterprise's account and sends payment directly to the appropriate treasury account. The bank verifies the enterprise account and follows the prescribed prior- ity for payment: (a) taxes, (b) loan repayment, (c) raw material purchase, and (d) profit. Step 7 The Industrial and Commercial Bank sends a full copy of the proceeding to the People's Bank with instructions about which treasury accounts are to be credited. Three copies of the payment statement go via the People's Bank to the Tax Bureau. There is a late payment fee of 0.6% daily. may be quite insignificant in another. By having provincial governments responsible for a wide range of tax administration, the central authorities in Beijing have been able to avoid the task of assembling and interpreting the huge amounts of information for administering the required entire tax system from the center. 4.49 Whatever the drawbacks of combining taxation and industrial policy (and there are many), the fact that the Tax Bureau is part of the same local government implementing industrial policy simplifies the administration of that policy. The synthesis of local government tax and industrial policy under one tier of government has permitted coordinated operations in the two policy areas, albeit at the cost of uncoordinated national and local govern- ment tax policies. 4.50 Finally, the involvement of local governments reduces remoteness of the tax authorities from taxpayers. For SOEs owned by cities and counties, the tax authority has usually been a department of the level of government that owns them. This enables the tax authority to keep informed about other aspects of their affairs such as trade licences, land occupancy rights and the like.  - 124 - 4.51 Weaknesses of Present System. However, there are disadivantages in the system. FTirst, the absence of a direct central government presence in cities and prov:inces has enabled the latter to pursue independernt industrial and other policies through the tax system. This can cause a shortfall in revenue and reduce the transparency of the tax system as implementation of tax policy deviates from the intentions of policy-makers. Moreover, the extent of this shortfall :Ls not known by the central government, in the absence of a management infiormation system. 4.52 The position of the directors of the various Tax Bureaus is ambigu- ous. These officials have to account to higher-level authorities for tax col- lection and tax policy implementation but are appointed by, and dependent for employment ancd promotion on the local governments. The close involvement of local governments with individual taxpayers may lead to a loss of objectivity. In 1989, a State Council decision to allow the SAT to nominate ]?rovincial Tax Bureau directors, should help strengthen the "vertical' administration of the tax administration. Assessment 4.53 Clearly the task at hand for the local tax authorities is very large, given the large number of potential taxpayers. These taxpayers are subject to a large number of different taxes, tax categories and tax rates. Some taxes, such as the adLjustment tax, require individual consideration. In view of this, the number, organization and skills of the administration personnel requires careful attention. Almost half a million tax cadres aciminister the major taxes such as the profits and turnover taxes, and the smaller taxes such as those on market transactions, real estate and the slaughter of animals. A single tax cadre may be responsible for two or three villages, with a number of rural enterprises and as many as 10,000--20,000 inhabitants. With the growth of the household sector and the increasing significance of the PIAT, this needs to be monitored. 4.54 There are problems in the areas of accounting and audit. There is only scant supervision of the local cadres who implement central policy by the central government. As a result, ilt is not clear how closely the actual tax system resembles the tax system desired by the center. 4.55 In China the system under which the SAT "shares resporLsibility' for tax administration with provincial and lower-level governments may be seen as an attempt to come to grips with the problem of remoteness in administration. However, the way in which this system works is such that the SA.T has formal responsibility but little prospect of influenciing administration. A symptom of SAT's relative lack of means lies in the fact that it has just 345 staff compared with between 400,000 and 500,000 employed by lower-level governments in tax administration. This makes it very difficult for SAT to ensure taxes are applied uniformly. In most unitary countries the central government directly employs its own tax administration and collection staff who are responsible for levying all central taxes. Moreover, the same is true for  - 125 - such major federal countries as the USA and India. A notable exception is West Germany where the tax offices are run by the States (Laender).61 4.56 The local collection of central taxes creates a number of potential problems noted elsewhere in the report. Interpretation and implementation of tax policy may vary widely across jurisdictions, leading to unintended inequi- ties and distortions. Secondly, if local jurisdictions do not apply the same tax effort as might be applied under a unified collection system, the control over actual revenue collections may be impaired. Special incentives provided by the central government in the new revenue-sharing system with local govern- ments suggest a problem with tax effort. These incentives for "tax effort" by local governments may themselves lead to an erosion of the revenues available to the central government. The next section discusses these problems in greater depth, and outlines some possible near- and medium-term options for strengthening tax administration. D. Recommendations and Reform Options for the Present System I. A National Tax Service 4.57 Immediate efforts have to be concentrated on exploring ways of improving the present administration and eliminating its least satisfactory aspects. The full and complete operation of an "IRS" or "Inland Revenue" type operation appears a long-term option but steps should be initiated in the near term to design its future structure. However, the role of a "National Tax Service' would be difficult to define in advance of a decision on the alloca- tion of taxes (or tax bases) between the central and local governments. Chap- ter III discussed four possible models for intergovernmental financing. Briefly, these were: (a) A centralized shared tax; (b) a balanced tax sharing model; approach under which the enterprise income tax and the product, busi- ness and value-added taxes would become fixed central revenues and local gov- ernments would be given only minor taxes; (c) Shared base, under which local and central governments would share in the base of the enterprise income and product, business, and value-added taxes; and (d) a reform of the present system which eliminated local government discretion to give tax concessions and standardized the retained shares of local governments. 4.58 A centralized tax sharing model effectively requires a separate NTS, as local bureaus cannot be relied on to collect taxes where they do not bene- fit from collection. In this case the NTS would collect the "central" taxes, with the local government collecting the "local taxes." This would involve the NTS in collecting most of the central taxes, now collected by local Tax Bureaus, and would call for a large, well integrated organization. It is unlikely that there would be any advantage in an NTS collecting any purely local taxes, unless these were on overlapping tax bases. 4.59 The "shared base" model does not make the NTS more or less feasible, per se, but its functions would differ considerably from an NTS under the 6/ But there exist complex mechanisms to ensure that responsibility is truly shared and that taxes are administered in a uniform manner.  - 126 - centralized model. The NTS (or a better coordinated decentralized (provin- cial) administration) could collect taxes on behalf of the central government, or could administer central and locaLl taxes jointly. A number of countries have both central and local income taxes that are charged on essentially the same base. Canada is an example of a country in which both federal and pro- vincial govermnents levy a tax on corporate profits. Both taxes are collected by Canada's National Revenue Service, but because the bases for the two taxes are broadly comparable, a single tax administration can collect both and account for them to the respective authorities. 4.60 In China, while it would also be possible under the shared base model to consider two separate tax administrations, each collecting taxes on behalf of its unit of government, such an approach would imply substantial duplica- tion and, given China's scarce administrative manpower, would be undesirable.7/ A "reform of the present system" is consistent with an NTS, but does not require it. As noted later in this chapter, present administrative arrange- ments, with substantially strengthened MIS and control would also support such a reform. 4.61 In the meantime, certain key steps towards improving thie present arrangements urgently need to be taken, including: (a) strengthened personnel and training; 'tb) a modern management information system (MIS) to strengthen the central management role of the SAT; (c) organizational changies within SAT itself, described below; (d) steps to strengthen the organization and staffing of local Tax Bureaus; and (e) administrative changes to improve the filing and payments system, and the assessment and audit procedures. II. Near-Term Steps to Strengthen the SAT 4.62 Immediate efforts must be concentrated on making the present system work better and eliminating the leas satis factory aspects of present arrange- ments. The keyr to improving the present arrangements lies in (i) the estab- lishment of a modern management information system (MIS), and (ii) the strengthening of the management role of SAT. To make this effective, a number of organizational. changes will be needed wiithin SAT itself. 4.63 Review of SAT Structure and Organization. The SAT inherited the organization of the former General Taxation Bureau of the MOF, whlich was essentially a policy-making unit. As it stands, the SAT is not staffed or equipped to identify and analyze the sorts of organizational and management problems confronting it. Early formation of a specialist organization and management unit within the SAT, with responsibility for reviewing the current organization of SAT, making recommendations for reform and implementing those recommendations (if approved by management), is essential. There are a number of areas where, on the basis of data already available, the case for early action in strengthening SAT seems clearcut. These are: 7/ As pointed out in Chapter III, the 'shared base" model could be administered by local government, who would, as at present, collect taxes on be'half of the central governmenLt.  - 127 - 4.64 Personnel. Strengthening the central SAT functions via recruitment of people with appropriate skills is essential. The staff of SAT has expanded rapidly in recent years, with large numbers of new graduates being recruited each year, and as a result the level of experience is relatively low. At the same time, there is no regular interchange of people between SAT and provin- cial governments, although such an interchange would benefit both the SAT and the provinces by creating a body of personnel with experience and understand- ing of work at both levels. Interchange of officials between provincial Tax Bureaus and SAT, as well as a rotation of the provincial officials themselves, should be introduced. 4.65 Training. An especially important task would be training, including the preparation of materials for in-house training and the identification of SAT's training needs and of the resources that would be required. In most countries, tax authorities find it desirable to supplement in-house training with outside materials and courses. In the case of SAT it seems likely that, at least initially, considerable use would need to be made of outside training facilities--particularly in specialized areas such as computers and modern audit, filing and work management techniques. 4.66 Management Information Systems. One of the main problems faced by SAT in its supervision of tax administration in China is the absence of data about the activities of the provincial, municipal and county areas and tax bureaus, reflected in the limited information in Section B of this chapter. Some figures are available centrally at SAT, on, for example, total tax col- lections and on the educational backgrounds of tax administration personnel. But few data are available on the activities or economic status of the major taxpaying enterprises--large state enterprises--and no attempt is made to obtain systematic evidence on the effectiveness of activities undertaken by provincial bureaus such as the examination of tax returns, or of the new pol- icy of "tax expenditures" described in Section B. Such data are indispensable if SAT is to control effectively the way national level taxes are adminis- tered. Therefore, design and installation of a modern management information system (MIS) is a priority task of the SAT. 4.67 The MIS would provide up-to-date information about the local tax base, enterprise activity and collections in the local Tax Bureaus area. It would show the progress in filing assessing, and auditing of returns and the results of work of local Tax Bureaus, and would highlight areas where inter- vention is desirable. It would provide both quantitative and qualitative data with statistical reports amplified by narrative reports. 4.68 Internal Audit Unit. To strengthen control over tax administration, the SAT should also establish an Internal Audit Unit staffed by specialist auditors the training of whom should now be initiated. Initially, the func- tion of this unit would be to advise provincial Tax Bureaus on measures they should take to improve internal security and apply national administrative standards, and to offer an internal audit service to the provincial govern- ments. At a later stage, this function could be expanded to cover the provi- sion of internal audit throughout the tax administration, probably through a network of provincial offices.  - 128 - 4.69 Standardizing Systems and Procedures. SAT should also play an active role in designing and enforcing standardized administrative systems and proce- dures. At present, there is considerable diversity of administriative practice throughout the country in areas where a more coordinated approach would pro- duce improved results. For example, the design of tax forms and filing proce- dures should be standardized across localities. Such standard forms would be a virtual necessity, for an invoice-based VAT, for example. A "Standard Sys- tems and Procedures Unit" within SAT would have responsibility for devising standardized, efficient and effective procedures, for designing fEiling forms and for collating and disseminating administrative "best practice" throughout the tax administration. The work of such a unit would also extend to reviewing the way in which local Tax Bureaus were organized and recommending changes to ensure an appropriate internal structure for local offices. 4.70 Automatic Data Processing. The volume of data that has to be handled by local Tax Bureaus makes the introduction of ADP not only desirable but, ultimately, inescapable. The number of possible applications is very large and it is likely that it will be desirable to introduce computers at all levels of the work. A central ADP unit within SAT would be needed to coordi- nate and guide this work at the local level.8/ 4.71 Implications for SAT Role and Organization. The above measures would alter dramatically the influence and structure of SAT. But this must be the case if SAT is to tackle successfully the tasks it faces as coordlinator at the national level of local government tax administration. Figure 4.2 is a very tentative organization model that might be adopted following the recommended management review. The large number of new tasks points to an additional deputy director post governing all the new functions. Responsibility for all operational work (except for the control of the Offshore Oil Taxation Bureau for which no change is envisaged), would lie with the additional post. The appropriate number of departments and divisions, and their respective func- tions, would be matters for the proposed management review. 4.72 The ultimate goal of reforms of SAT structure and organization may be the establishment of a National Tax Service to administer all central and shared (as distinct from local) taxes, staffed entirely by employees of the central government. This service would set up its own Tax Bureaus throughout the country and take the administration of certain national level taxes from the provincial and lower-level governments altogether. Paradoxically, by ensuring a unifonn tax environment, such centralization would facilitate decentralization of decision-making to enterprises. They would operate within a regime of certainty. However such a National Tax Service is not a realistic goal in the near or medium term. 8/ Among its functions would be: (i) Although the creation of a monolithic centralized computer system is premature, even at early stages the exchange of data requires compatibility in computer hardware and software and the nature and form of data inputs. A central ADP unit would be responsible for design and compatibility standards within the provinces' systems. This would also ensure that obsolete hardware is not purchased by local areas. (ii) Insofar as the tax administration developed its own software, a central unit would carry out and monitor that work, provide a forum for the exchange of information, and function as a resource center for the entire administration.  - 129 - Figure 4.2: TENTATIVE ORGANIZATION CHART OF THE SAT FOLLOWING A MANAGEMENT REVIEW | DIRECTOR| |Deputy Director | euyDirector ||Deputy Director (Management) || (iet Taxes) (Indirect Taxes.)| Business ersona offshore oil Troe Divisions: rmato Taxation Bureau Recruitment ADP Collections and Career Organization MIS Planning Procedures and Research Pay Forms Internal Audit Audits Training Instructions Investigations and Enforcement Development Planning Penalties  - 130 - III. Organization and Strengthening of Provincial and Lower-level Offices 4.73 Role of Provincial Tax Bureatus. The present pattern of provincial Tax Bureaus supervising the work of bureaus at city and county level has many good features. However, it is desirable that some of the functions performed by provincial bureaus (for example, tax policy functions and the task of devising and publishing administrative regulations) should be performed only at the center by SAT. 4.74 Resolution of 'Dual Leadership' Problems. Major ambiguities arise in the existing hierarchy of tax bureaus. These relate firstly to Tax Bureaus directors--and secondly to "Affiliated Counties'. The position of the Tax Bureaus directors at all levels should be clarified so that they are responsi- ble only to one superior authority. In the interests of enhancing uniformity of tax administration treatment and objectivity of administration the hierar- chy should be: (i) SAT for provincial Tax Bureaus; and (ii) the provincial Tax Bureaus for municipal and county tax bureaus. The "dual responsibility" of provincial (or Local) Tax Bureaus to the provincial (or local) Finance Bureau should cease. Likrewise, it is desirable that the position of 'affiliated counties" should be clarified so that they are other fully integrated within and responsible to city tax bureaus. Their present "half-way" status is unsatisfactory. The 'vertical' management approach proposed to be introduced in 1989, in faced achieves this as between the SAT and provincial Tax Bureaus. 4.75 City and County Tax Bureaus. At the city and county leviel, what is possible is severely constrained by difficulties in communications. The pres- ent system of tax bureaus with their satellite "branches" and "tax stations" appears to be justified by the need to provide a presence in distsant towns and villages. However, it also leaves many officials remote from their immediate superiors, making it difficult--in the absence of an MIS--to control the way they work, and leaving local tax officials vulnerable to pressure's from tax- payers and local government officials. The practice of posting "resident tax officials" within enterprises makes this especially acute and givess major cause for concern. Such officials run the risk of identifying too closely with the enterprise they are supposed to monitor. 4.76 Resident Officials and Staff Rotation. SAT officials in Beijing have spoken of encouraging the rotation of resident officials every couple of years or so to reduce their exposure to pressure from individual enterprises. How- ever, while this step will undoubtedly be of some value, it will do nothing to remove the inherent ambiguities in the officials' terms of reference. A way needs to be found of separating the two functions, restoring to the tax admin- istration the objectivity that is essential if the tax system is to work as policymakers internd. 4.77 Indeed, the Chinese authorities might consider building on the strengths of "resident tax officials" in order to develop the accounting pro- fession. For example, assuming enterprises will in future be responsible for filing their own returns and for making tax payments without the need for official assessments, some of the resident officials could be transferred to the employment of individual enterprises as :internal accountants. Resident advisors could also become employed by independent "tax advisory enterprises"  - 131 - that were in the business of giving tax advice. They would offer their ser- vices on an agency basis and in return for a fee they could also prepare tax returns and other tax documents on behalf of the enterprise. To be success- ful, the resolution of the resident official's role must achieve a complete separation of the function of tax official/auditor and representative of the government/owner of the enterprise and, for the purpose of conducting tax audits, replace the system of resident officials with one that ensures an objective evaluation both of tax liabilities and of tax expenditures. IV. Near Term Administrative Reforms: Micro-Level Administrative Measures 4.78 While any full reform of the tax administration system will take time, action in a number of areas seems immediately feasible and could contri- bute significantly to the efficiency of the tax operation now. 4.79 Laws and Regulations Should Take Account of Administrative Feasibil- ity. Often "tax administration is tax policy".9/ Practical administration of the tax system should be in the forefront of policy decisions, suggesting simplicity, fewer different tax regimes, fewer rates and the elimination of negotiated preferences. One approach that has been adopted with some success in developing countries is the use of "presumptive" measures of income for certain groups whose precise income is difficult to measure (see Section A). 4.80 Make PIT and PIAT Annual Taxes, Reduce the Number of Formal Returns. Second, all income taxes should--as they are in virtually all other countries --be annual taxes (at present the PIAT and the PIT are monthly based) with supporting returns and accounts rendered just once a year (at present, such documents are submitted and checked up to 12 times a year, each time a tax payment falls due). Besides permitting a simpler set of computational rules for the personal taxes, this approach would greatly reduce the administrative burden for tax bureaus and taxpayers alike. 4.81 Simplify Payment of Taxes; Standardize Forms. Third, and implicit in the above proposals, is a simplification and standardization of the arrangements under which taxpayers actually pay their taxes. The present system depends on the generation, in the Tax Bureau, of the six-part payment notice matched by entries in the Tax Bureau's records for the taxpayer. Under the arrangement for tax payment and self-assessment described above, the tax- payer would himself complete a standardized, pre-printed form (designed by SAT), and submit one copy to the Tax Bureau and one or more copies to the bank. There seems little reason why more than one copy of the form should then go from the bank to the Tax Bureau because there will be only one open entry to be closed off. For the payment of VAT, the standard invoice form should show the VAT actually paid. This is essential to move away from the present system of presumptive crediting to a system of invoice-based VAT. 4.82 Unique Taxpayer Numbers. In most countries standardized pre-printed forms on which taxpayers notify tax offices of their liabilities bear a unique taxpayer identification number. In the US, for individuals, this is the 9/ See M. Casanegra de Jantscher: "Problems of Administering a Value-Added Tax in Developing Countries," IMF FAD WP/86/15, p. 18.  - 132 - wsocial security number". For enterprises, it is usually an assigned number, used by the enterprise in all of its dealings with all types of officials; that is, the same number is used for trading licences, subsidy applications, and other tax-related forms. This enables tax authorities to keep a full record of all tax payments with an enterprise's tax liabilities. The number can also be used on invoices issued by traders and on employers' and contrac- tors' records. This enables the tax authorities to trace payments, to ensure that taxable amounts are properly included in tax returns, and to ascertain that tax reclaimecd has actually been paid. Although the fullest benefits of unique taxpayer identification numbers are obtained in fully automated sys- tems, many benefits can be realized in a manual system. The Chinesse govern- ment should consider introducing a system of unique taxpayer identification numbers. 4.83 Introduce Self-assessment for Turnover Taxes and Income Taxes. Fifth, all turnover taxes should be paid automatically each month or quarter without the submission of detailed returns or accounts. This wou]Ld consider- ably reduce the volume of paper handled by Tax bureaus. Each monthly or quar- terly period couldl be regarded as an entity in itself, without the need for an annual reconciliation. (Tax over- or underpaid in any given period would be adjusted when/if errors or new information came to light). Self-assessment could also, in time, and as expertise develops, apply to taxes on enterprise profits and other income so that taxpayers took responsibility for calculating their own liabilities and the role of tax administrators was confined to moni- toring and auditing taxpayers' performance. 4.84 Direct Payment to Tax Bureau of Taxes Due. At present, enterprise taxes are remitted via the taxpayer's bank to the Tax Bureaus, giving rise to large numbers of transactions between the Tax Bureaus and the banks. In the absence of advanced computerized accounting systems, the payment of tax directly to Tax bureaus might, by substantially reducing the number of trans- actions between banks and tax bureaus,, offer considerable administrative advantages. 4.85 Methods of Tax Collection ancl Audit: The Need for Selectivity. It was noted earlier that China's tax collection procedures are especially weak in terms of incremental revenue yield for additional collection efforts. This disappointing performance may be tracE!d to the apparent absence of selectivity in tax audit and examination. The limited scrutiny possible, if every case has to be examined, means the ability of tax administration to detect serious offenders is greatly hampered. To improve the effectiveness of the current audit effort, the application of systematic management must be brought to bear in ways it can ble most effective. At the same time, it is desirable to make the best use of trained and experienced personnel. 4.86 The proposal for self-assessment outlined above will, by making tax- payers increasingly responsible for making their own tax returns, release tax bureau staff for more productive work and provide an opportunity to introduce over a period of two or three years a well-balanced program of selective audits. While bearing in mind that, in the transition period, staff would still have to operate the old system, such a timescale would permit at least  - 133 - key personnel to undergo training in suitable techniques and allow time for the collection of data on which selection would be based. Transition: Some General Considerations 4.87 The near term measures for streamlining of filing and tax payment procedures outlined above would result in a very substantial reduction in the amount of paperwork to be handled by the local tax administrations. While there would be a risk that some taxpayers would fail to comply with their responsibilities, leading to a loss of revenue, careful preparation ought to ensure that that risk was minimal. There are a number of precautions that could be taken. 4.88 Provide and Enforce Penalties. At the same time as the relevant regulations were being drawn up, a review should be undertaken of the provi- sions for penalties for taxpayers who deliberately or negligently fail to meet their proper tax liabilities. In some countries late-paid taxes automatically attract a significant financial penalty and while the 1986 Tax Management Regulations provide for a 0.5Z daily surcharge payable in case of late pay- ments it appears that this provision is rarely enforced. 4.89 Allow Time for Adjustment. It is essential that adequate time be allowed to enable both tax administration and taxpayers to prepare for the new procedures. Experience has shown that a minimum period of between one and tt-o years is required to devise and print new forms, to train staff and to educate taxpayers. In this respect it should be remembered that in the preparatory period both taxpayers and tax administration will continue to operate the old system as well as learning about the new one. 4.90 Publicity and Taxpayer Education are of key importance. A factor to stress here would be that in the new regime it would be the taxpayer who would bear responsibility for making prompt and accurate returns and payments. Accurate, accessible and well-timed information can greatly improve voluntary compliance and most tax administrations find that expenditure in this area can quickly pay for itself in terms of improved tax collections and lower adminis- tration costs. 4.91 Support Development of an Audit/Public Accountancy Profession. Enterprises would be expected to ensure that they had access to the expertise necessary to enable them to fulfill their duties. In some cases this might mean that they recruited specialist personnel. In other cases, it might be more expedient for them to establish contacts with other entities that had such personnel. These might include both other industrial or commercial con- cerns and specialist firms of consultants or advisers. The tax authorities should consider it part of their function to set minimum standards for the training and testing of enterprise tax specialists. 4.92 Run Pilot Schemes. It is highly desirable that all the new proce- dures be tested by SAT in at least one pilot area, chosen to be as representa- tive as possible. This would enable both the procedures and the training and education techniques to be evaluated by the SAT and allow the SAT to make any  - 134 - improvements needed before they were applied by the SAT nationwidle. The time needed to mount and evaluate the pilot could be used to begin the! task of familiarizing taxpayers and tax administrators in the rest of the! country with the principles of the proposals, thereby permitting a gradual adjustment to the new rules.  Tab I e I: STATE BUDGET REVEMJE, 1978-89 /u (In billions of yuan) Growth 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1B88 1988 1989 rate Buoyancy Budget Actual Budget 1978-89 1978-89 Tax revenue /b /c 120.6 122.7 128.1 135.4 136.8 153.5 175.5 218.8 224.8 231.6 251.5 257.6 276.2 8.6% 0.61 Taxes on income and profits 74.0 73.7 75.6 77.1 72.1 75.1 80.6 69.7 69.3 66.5/d 63.7 67.6 57.3 -2.5% -0.15 Enterprises income tax 74.0 73.4 75.4 76.7 71.6 72.6 78.0 69.7 69.3 61.5 63.7 67.6 57.3 -2.5% -0.15 Collectives la (5.4) (4 5) (4.5) (4.4) (4.8) (6.0) (6.2) (10.1) (9.7) (10.2) (10.8) (10.5) (11.6) (7.9%) (0.73) State enterprises /f (68.6) (68.9) (70.9) (72.3) (66.8) (66.6) (71.8) (59.6) (59.6) (51.3) (56.5) (57.1) (47.5) (-3.6%) (-0.24) Other 0.0 0.3 0.2 0.4 0.5 2.5 2.6 0.0 0.0 5.0 4.4 0.0 0.0 34.8% Taxes on goods and services 43.7 46.4 49.1 52.8 58.6 60.2 71.4 100.5 109.6 114.1 129.5 132.5 149.5 13.1% 0.88 Ceneral sales taxes L2 39.5 42.5 45.4 49.1 54.7 55.9 66.9 95.3 104.0 108.7 124.4 126.3 142.7 13.7X 0.91 Product tax (0.0) (-0.) (0.0) (0.0) (0.0) (0.0) (0.0) (59.4) (54.7) (53.6) (54.8) (48 1) (52.5) (-3.0%) (-0.25) Value-added tax (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (0.0) (14.8) (23.2) (25.0) (33.8) (38.4) (42.2) (29.9%) (1.66) Business tax (0.0) (0.0) (0.0) (0.0) (0-0) (0.0) (0.0) (21.1) (26.1) (30.1) (35.8) (39.8) (48.0) (22.8%) (1.32) Salt tax 1.1 1.0 0.9 0.9 1.0 1.0 1.0 1.0 1.1 0.4 0.7 0.9 0.8 -3.1X -0.24 Agricultural tax 3.1 2.9 2.8 2.8 2.9 3.3 3.5 4.2 4.5 5.0 4.4 5.3 6.0 6.8X 0.53 Taxes on international trade 2.9 2.6 3.4 5.4 4.7 5.4 10.3 20.5 15.2 15.0 15.0 15.5 19.2 20.8X 1.44 Other taxes 0.0 0.0 0.0 0.1 1.4 12.8Lh 13.2 28.1 30.7 36.0 39.7 42.0 50.2 117.6% 3.87 Of which: Tax on extrabudgetary receipts 0.0 0.0 0.0 0.0 0.0 9.3 12.2 14.7 15.7 17.5 18.1 18.6 20.5 14.1% 0.74 Tax on extrabudgetary construction 0.0 0.0 0.0 0.0 0.0 0.2 1.0 2.3 2.4 2.9 2.5 2.6 2.5 52.3X 2.15 Nontax revenue 2.7 3.6 3.5 3.2 4.4 5.9 8.0 9.5 19.5 24.6 22.9 29.1 39.6 30.8X 1.89 Gross profit remittances from tn SOEs Li . .. . .. .. .. .. 4.4 4.2 4.2 4.6 5.1 4.0 -2.4% 0.03 Depreciation funds 2.4 2.5 2.7 2.6 2.6 2.7 2.7 0.0 0.0 0.0 0.0 0.0 0.0 2.0% 0.16 Other 0.3 1.1 0.8 0.6 1.8 3.2 5.3 5.1 15.3 20.4 18.3 24.0 35.6 61.2X 3.09 Total revenue Li 123.3 126.3 131.6 138.6 141.2 159.4 183.5 228.3 244.3 256.2 274.4 286.7 315.8 9.9% 0.68 Memorandum item: Total gross profit remittances from SOEs 68.6 68.9 70.9 72.3 66.8 66.6 68.7 4.4 4.2 4.2 4.6 5.1 4.0 -24.7% -2.55 GNP in current prices 358.8 399.8 447.0 477.3 519.3 580.9 696.2 856.8 972.6 1135.1 1385.3 1385.3 1567.7 15.91 /a This includes all government revenue, with the exception of extrabudgetary receipts of the various levels of government. No detail is available on a disaggregated basis for 1988 actual revenues. /b Proceeds of the profit tax on state enterprises introduced in 1983 are classified under profit remittances, as the breakdown of enterprise payments in 1983 and 1984 between profit tax and profit transfers is not avai lable. Beginning with 1985, profit taxes on state enterprises are included under tax revenue. /c Chinese definition of tax revenues plus energy and communications tax. Residual: 231.0 less all identifiable items below. /j Until 1985, the industrial and commercial income tax levied on collective enterprises. Beginning in 1986, official data no longer separately identify income tax on collectives. /f The profit tax and adjustment tax on state enterprises, gross profit remittancies from state enterprises unti l 1984. /9 The consolidated industrial and commercial tax. 1k Includes Y 1.9 bi I I ion from the tax on crude oi l consumption introduced in 1982. /i According to the definition contained in IMF Manual on Government Finance Statistics iGFS?, 1986. E Until1 1984, included in income tax on state anterprises, as of 1988, only banks and financial institutions are subject to remittance. Source: Ministry of Finance and World Bank/IMF estimates.  Table II: FUNCTIONAL CLASSIFICATION OF STATE BUDGET EXPErNDTURE AND NET LENDINC, 19)78-89 (In billions of yuan) 1978 1979 1980 1981 1982 198.3 1984 1985 1988 1987 1988 1988 1989 Growth rat. Budget Actual Budget 1978--89 Total expenditure and net lending La 122.5 146.9 146.4 144.4 148.3 169.0 193.9 232.4 263.3 281.5 .305.0 321.3 346.2 10.91 Current expenditure 69.2 86.2 99.1 107.1 113.2 126.4 138.1 168.1 188.1 204.4 226.9 239.8 267.4 14.51 Administration 4.9 5.7 6.7 7.1 8.2 10.1 13.7 14.4 16.8 17.9 18.1 22.1 22.7 16.61 Defense 16.8 22.3 19.5 16.8 17.6 17.7 18.1 19.2 20.1 21.0 21.5 21.8 24.6 3.91 Culture, education, public health 11.3 13.2 15.7 17.0 19.7 22.3 26.3 31.7 38.0 40.3 44.7 48.6 51.7 16.51 Of which: Education (.) (. .) (. .) (.) (14.8) (18.4) (21.4) (22.7) (25.4) (27.9) (29.9) (15.11) Economic services 17.9 18.7 19.2 16.8 17.6 18.8 20.4 22.4 25.2 26.0 27.9 28.9 31.3 5.81 Geological survey C.) (. .) (. .) (.) (2.6) (3.0) (3.1) (3.0) (3.1) (3.3) (3.4) (5.51) Agriculture (.) (. .) .) (. .) (9.6) (10.1) (12.4) (13.4) (15.4) (15.4) (17.4) (12.61) Operating expenditur, for industry, comemunication and commerce (.) (.) (. .) (.) C C.) (3.0) (3.5) (3.7) (3.3) (3.2) (3.9) (4.0) (5.91) Development of new products (..) C..) (.) .) (.) (.) (4.2) (4.4) (5.0) (5.1) (5.4) (5.3) (5.6) (5.91) Working capital for SOEs (..) (..) (.) (.) C..) C..) (1.0) (1.4) (1.0) (1.2) (0.8) (1.0) (0.9) (-2.11) Subsidies 11.4 19.5 27.4 36.8 37.2 42.6 41.0 50.7 58.2 67.0 76.5 76.3 93.1 23.41 Daily living necessities /b (7.8) (16.0) (24.0) (30.5) (30.0) (30.9) (31.5) (31.4) (25.7) (29.5) (35.8) (31.7) (41.0) (18.01) Agricultural inputs (..) (..) (..) (2.2) (2.1) (1.4) (1.0) (1.3) (..) (..) (..) (..) (..) (-12.01) Operating losses of SOEs (3.6) (3.5) (3.4) (4.2) (5.2) (10.3) (8.5) (18.0) (32.5) (37.5) (40.7) (44.8) (52.1) (30.81) in~terest payments .. . . . . . . . .2.4 3.2 3.2 4.0 29.11 Other 6.9 6.8 10.7 12.6 12.8 15.0 18.6 29.7 29.8 29.2 35.0 38.9 40.0 19.31 l Capital expenditure 53.3 60.7 47.3 37.3 35.1 42.6 -55.8 64.3 75.2 77.1 78.1 81.5 78.8 4.01 Capital construction k . .. . . . . 48.9 58.4 67.2 69.7 71.3 71.8 71.8 8.01 Development of the productive .. . . . . . .9 5.9 8.0 7.4 8.8 9.7 7.0 0.31 capacity of existing enterprises Memorandum items (as percent of ONP Current expenditure 19.3 21.6 22.2 22.4 21.8 21.8 19.8 19.6 19.3 18.0 18.1. 17.3 17.1 -1.211 Subsidies 3.2 4.9 6.1 7.7 7.2 7.3 5.9 5.9 6.0 5.9 5.4 5.5 3.9 6.51 Daily living necessities (2.2) (4.0) (5.4) (6.4) (5.8) (5.3) (4.5) (3.7) (2.6) (2.6) (2.5) (2.3) (2.6) (1.81) Operating l oss es of SOEs (1.0) (0.9) (0.8) (0.9) (1.0) (1.8) (1.2) (2.1) (3.3) (3.3) (2.9) (3.2) (3.3) (12.91) Capital expenditure 14.9 15.2 10.6 7.8 6.8 7.3 8.0 7.5 7.7 6.8 5.6 5.9 5.0 -10.31 (as Percentage of total expenditure) Subsidies 9.3 13.3 18.7 25.5 25.1 25.2 21.1 21.8 22.1 23.8 25.1 23.7 26.9 11.21 Capital expenditure ~43.5 41.3 32.3 255.8 23.7 25.2 28.8 27.7 28.6 27.4 27.8 25.4 2_2. 8 -8.3% GNP in current prices (billion yuan) 3.58.8 399.8 447.0 477.3 519.3 580.9 696.2 858.8 972.8 1.1.35.1 1,385.3 1,385.3 1.567.7 15.91 According t. the definition contained in IMF, Manual on Government Finance Statistics, 1986. Lb In 19)86, data for price subsidies for people's l iving necessities cover only domestically produced items; data for operating losses of state-owned enterprises include also subsi d ies on i mported da ily necessitieas and agr iculIturalI i nputs; off icialI data do not i denti fy these i tems separatelIy. LS Includes entrabudgetary capital construction of Y 6.9 bill Iion in 1987. Y 8 bill Iion in 1988 (budget)., Y 8.5 bill Iion in 1988 (actual), and Y 9 bill Iion in 1989 (budget). Source: Ministry of Finance; and State Statistical Bureau.  Table !II: SUMMARY OF THE TAX SYSTEM: STATE 5.JDCET, 1988 Tax Natur- of tan Exemptions and deductions Rates I. Tea.s on Net Income and Profits Texas on companies, corporations and en te rp r i es I Incom-e tax on tste.-owned enter- (a) A tan on profits of large and medi.. (a) For profits realized in 1983 by the (a) Medium and large nterpriss. are taxes prises stabe-oneed enterprises Different taxpayer, appropriate adjustments at a r.at of 55%. In addition, a provisions apply for small enter- should be cede in the balance of the variable readjustment tax is levied on prises. increased or decreesed profits caused aece.. profits arising from factors by changes in the rates of the product external to enterprises, such as the teax, the v-lue added tax, and sales price structure. tax or by the levy of a resource tan. For lox-profit enterprises that are (b) Sme1l enterprises are t-xed according not able to retain the reasonable to the same progr-ssive scale as appraised amount of profit, the levy applied to collective enterprises of income taxes nay be exempted for a under the industrial and cammercial period of three years. income tax. (b) Regarding the incomes earned by subsi- diary enterprises of government agen- cies, institutions, the military and social organizations, if such incomes are spent to offset institutional xx- penditures, they should be exempt frin income tax for the time being; if not, they should be levied an income tax as required. (c) Regarding the industrial plants set up by co.mmrcial esteblishmants (includ- ing those set up by grain-handling as- tablisheente), which specialize in the production of soy sauce, vingar, soy products, pickles, bean paste, smoked foods, pastries, food for children, sweets, preserved fruits, fruit juices and jams, dried vegetables and condi- mnente (but not including MSG), and r- garding feed processing plants, the appropriate tax rates should be ap- plied to levy an income tax but only half of the amount due should actually be collected within the time periods i specified. As regards those plants that spe- cialized in the products mentioned above set up by other sectors, the . same rul- pplies but may be modified W accordin1g to circoetance.. H H  T.ble III: (cont'd) Tax Nature of tax Exemptions and deductions Rates 1. (cont'd) In the case of .em feed processing plants, income taxes should bh exempt for three years- in the ease of cone types of nec food processing plants, the exemption period should be one year. After the exemption period is op, if the taxpayer still has diffi- cu ties, tax reductions for a fixed period may be granted, pending appeal and apPronal in accordance with sat procedures. (d) Extraordinary circumstances such as natural disasters including high einds, fire and floods ehere tax re- ductions or exemptions are needed, the tax agency, follo-ing the authority nested in it by these Regulations, may either grant a one-time reduction or exception or periodic reductions and w easeptione. When the exempt period is 0