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

Report No. 7605-CHA China: Revenue Mobilization and Tax Policy Issues and Options (In Two Volumes) Volume II: Annexes June 15, 1989 Country Operations Division China Department Asia Region fOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official du; ies. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVFLFNTS The Chinese currency is called Renminbi (RMB). It is denominated in Yuan (Y). Each Yuan is 1 Yuan = 10 jiao = 100 fen Calendar 1988 June 1989 US$1.00 = Y 3.72 US$1.00 = Y 3.72 Y 1.00 US$0.27 Y 1.00 - US$0.27 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System LIST OF ACRONYMS MOF - Ministry of Finance GTB - General Taxation 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 GES - Government Finance Statistics VAT - Value Added Tax PIT - Personal Income Tax PIAT - Personal Income Adjustment Tax CICT - Consolidated Industrial and Commercial Tax ICIT - Industrial and Commercial Income Tax  FOR OFFICIAL USE ONLY CHINA REVENUE MOBILIZATION AND TAX POLICY ISSUES AND OPTIONS ANNEXES Table of Contents 1. REFORMING THE TAX STRUCTURE A. Key Features of China's Present Tax System B. Impact of the Current Tax Regime C. Recommendations ,-ppendix 2. CENTRAL-LOCAL FISCAL RELATIONS AND REVENUE SHARING A. Fiscal Decentralization and the Role of Subnational Government: Principles, Criteria and International Practice B. Governmental Decentralization and Local Finance in China C. Taxation and Revenue Sharing D. Intergovernmental Fiscal Relations E. Problems and Issues in Subnational Finance F. Options for Reform 3. TAX ADMINISTRATION A. An International Perspective on Tax Administration B. Tax Administration and Collection in China C. Analysis and Issues D. Recommendations and Reform Options This document r petr>"o.l d 'rs tinn and tr v*  ANNEX 1 CHINA REVENUE MOBILIZATION AND TAX POLICY ISSUES AND OPTIONS Annex 1: Reforming the Tax Structure Table of Contents La-e No. Summary and Conclusions .............................................. i A. Key Features of China's Present Tax System. 1 Historical Background .1 The Current Tax Regime. 3 Product Tax. 3 Value Added Tax. 3 Business Tax. 6 Implicit Indirect Taxes. 7 Resource Tax. 8 Enterprise Income Tax. 8 State Enterprises. 9 The Enterprise Income Adjustment Tax ....................... 10 Extrabudgetary Fees ........................................ 12 After Tax Profits .......................................... 12 Contract Responsibility System for State-Owned Enterprises .............................................. 13 Collective Enterprises ..................................... 15 Individual Household Enterprises ........................... 16 Joint Ventures ............................................. 16 Foreign Enterprises ........................................ 17 Agricultural Taxation ...................................... 18 Taxes an International Trade ............................... 19 Taxation of Individual Incomes ............................. 20 Other Taxes ................................................ 23 B. Impact of the Current Tax Regime .............................. 24 Indirect Taxes ................................................ 24 Implicit Subsidies ......................................... 25 Profitability .............................................. 26 Cascading .................................................. 28 Equity ..................................................... 31 Size-Dependent Taxation ..................................... 31 Enterprise Income Tax ......................................... 31 Statutory and Effective Rates of Tax ....................... 34 Resource Tax ........................................... 4 Agricultural Taxation ......................................... 36 Taxes on International Trade .................................. 36 Personal Income Adjustment Tax ................................ 37 Taxation as Industrial Policy ................................. 37  ANNEX 1- - ii - C. Recomm.endations ............................................... 38 The Value Added Tax ........................................... 38 The Existing VAT ........................................... 40 The Rate Structure ............................................ 41 Rate Structure: Comparative Experience ..................... 42 Price Control and Enterprise Profitability ................. 44 Retail Price Decontrol ..................................... 44 Intermediate Good Price Decontrol .......................... 46 Standard VAT Rate .......................................... 49 Revenue Growth ............................................. 52 Business Tax ............................................... 53 Taxation of Enterprises ....................................... 53 Taxation and Contracting ................................... 53 Taxation versus Ownership .................................. 55 The Enterprise Income Tax .................................. 56 Revenue and Profitability .................................. 58 Resource Tax ................ 62 Personal Income Taxation ................ 63 Revenue Implications of Tax Reform ................ 64 Appendix: The Calculation of Cascading Effects of Indirect Taxation TABLES IN TEXT Table 1 China: State Budget Revenue, 1978-1988 .................. 2 Table 2 Product Tax Rates on Major Product Groups ............... 4 Table 3 Value Added Tax Rates on Major Product Groups ........... 5 Table 4 Rates of Business Tax ................................... 7 Table 5 Export Taxes ............................................ 21 Table 6 The Effects of Tax Cascading ............................ 30 Table 7 China: Marginal Effective Tax Rates for Investment in Fixed Assets by Type of Enterprise ................. 35 Table 8 The Rate Structure of VAT in Selected Countries ......... 43 Table 9 Effects of Value Added Tax Changes on Sectoral Profitability ......................................... 48 Table 10 Growth of Indirect Tax Revenue in Selected Countries .... 54 Table 11 Amortizati n of Bank Loans by State-Owned Enterprises, 1986 .59 Table 12 Enterprise Profitability with and without Principal Deluctibility ................................ 60 FIGURES Figure 1 Allocation of Enterprise Income ........... ............. 11 This annex was prepared by Mr. Pradeep Mitra, of the Public Economics Division, Country Economics Department.  ANNEX 1 CHINA REVENUE MOBILIZATION AND TAX POLICY Summary and Conclusions 1. Part A of this annex describes the key features of the tax system in China. Indirect taxes, mainly comprising (i) the product tax (a turnover tax), (ii) the value-added tax on domestic manufacturing and imports and (iii) the business tax on services and, to a lesser extent, (iv) the agricultural tax on yield of grain, account for nearly half of central government tax revenue. Income taxes on State enterprises and collectives make up 35 percent of tax revenue; of this, over 80 percent comes from State enterprises. Yowever, 60-70 percent of State enterprises are under the contract management responsibility system (CMRS), a variant of the contractual responsibility system that, inter alia, allows considerable negotiation in the determination of tax obligations of State enterprises. Customs duties on international trade comprise 7 percent of tax revenue and appear to play a predominantly protective role. Tax revenue for local governments de,ives from a combination of local taxes and surcharges on central taxes. Some 40 percent of consumer goods and 60 percent of intermediate goods are believed to be transactea at State-controlled prices. 2. The system of price controls has led to a complex structure of product tax and VAT rates in order to attP-pt equalization of enterprise profitability across sectors of the eco' . However, in common with many other countries, the VAT exempts agricu,.are, zero rates exports and treats domestic production and imports symmetrically. In addition, sumptuary excises are levied on selected commodities. A noticeable feature of the enterprise income tax is the deductibility of principal as well as interest payments on bank loans used to finance fixed investment. State enterprises may deduct all of principal and interest while collectives are allowed 60 percent of principal and all of investment. 3. Part B describes the impact of the current tax regime. It illustrates the subsidy implicit in price controls on non-agricultural final goods. The effect ,f taxation of raw materials via the product tax and business tax is shown to result in significant cascading of indirect taxes; this effect is less serious for industries subject to VAT. Indirect tax rates in the fix price sector of the economy are used to equalize profitability across sectors, with a view to allowing enough after tax profits to finance investment and workers' bonuses. However, tax rates set with reference to such considerations have the potential for intensifying price distortions in the flex price economy. Part B also argues that the CMRS can be expected to subtract from the elasticity of the enterprise income tax, and to allow the authorities a degree of discretion that is excessive from the point of view of the emergence of competition. And the inclusion of tax payments in contracts removes a potentially important instrument of macroeconomic management from government control.  ANNEX 1 - ii - 4. Part C recommends that the existing Product Tax/VAT be replaced by a consumption type VAT, implemented via the invoice method, exempting agriculture and services, zero-rating exports and embodying the destination principle. The paper presents cross-country evidence for the buoyancy of such a tax. It is recommended that the VAT rate structure for intermediate goods be simplified significantly. The VAT applying to final goods could however be simplified and the entire rate structure unified only in the event of price reform. The administration of the business tax should be strengthened prior to consideration of a second stage of reform where it is replaced by an extension of the VAT through the wholesale and retail levels. 5. It is recommended that the income tax be applied to all en.er- prises to satisfy the requirements of the State as tax collector. Lowering the current statutory income tax rate should only be considered in conjunction with the tax treatment of depreciation, amortization and interest to help focus on the effective tax rate facing enterprises. In particular, the statutory rate of tax fhould not be reduced till tax preferences prevalent under the contractual responsibilities system are done away with. The cJntractual responsibility system should be restricted to after tax profits, whence it could evolve into an instrument for valuing enterprise net worth, with a view to making dividend-like payments to the State as owner of fixed assets. It is also suggested that consideration be given to narrowing the range of available contracts to a few "standard" archetypes that would apply to all ,nterprises. The tax-deductibility of amortization payments should be discontinued for new borrowing for investment. 6. It is recc.mmend..d that consideration be given to strengthening the administration of the personal income adjustment tax, an instrument that has the potential of being progressive in incidence and, hence, of attenuating the inequalities in income that attend liberalization. 7. Turning to revenue implications, a standard rate of VAT at 15 percent, supplemented by selected sumptuary excises, could raise as much revenue as the existing produ,.t tax, VAT and excises. An increase in revenue requirements in order to re-establish macroeconomic control prior to price reform could be accommodated through a temporary across-the-board levy on indirect taxes on top of the VAT without disturbing the exempt status of agriculture and the zero rating of exports. It is shown that the price decontrol of non-agricultural finLal goods could raise revenue of the order of 20 percent of product tax-cum-7AT revenue. This could permit some subsidization to compensate for the abo'.ition of price controls. 8. Finally, it is illustratively estimated that the effect of disallowing tax-deductibility of amortization of new bank loans to State enterprises for fixed investment would be to add around 10 percent to revenue from the enterprise income tax.  Annex 1 Page 1 CHINA REVENUE MOBILIZATION AND TAX POLICY Annex 1 Reforming the Tax Structure A. KEY FEATURES OF CHINA'S PRESENT TAX SYSTEM 1.1 As is the case with most countries, China has a very large number of taxes but only a small number of them raise substantial revenues (see Table 1). The principal revenue-raising instruments are indirect taxes on goods and services (Product Tax, Value Added Tax and Business Tax) and the Enterprise Income Tax, followed by CuEtoms Duties and the Agriculture Tax. Taxes that raise smaller amounts of revenue include Resource Tax, Enterprise Income Adjustment Tax, Personal Income Tax, Personal Income Adjustment 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 Vehicle and Boat Tax. Historical Background 1.2 Prior to 1978 state enterprises remitted all profits to the state. Fiscal reforms were initially aimed at improving efficiency of state enterprises and involved the substitution of taxation for full profit remittance. A trial system of profit retention-cum-taxation was introduced for selected enterprises in Sichuan province in 1978. The experiment was successful and by the end of 1980, 6,600 state-owned industrial enter- prises, accounting for 16 percent of the total number of such firms but 60 percent of their output value and 70 percent of their profits, i.e., most large- and medium-sized firms, were on the system. This first phase of enterprise reform culminated towards the end of 1983 with ovet 90 percent of profitable state enterprises adopting profit retention. 1.3 The second stage of enterprise reform involved the restructuring of indirect taxation and the creation of a dual pricing system. Up to 1983 the indirect taxation of enterprises was carried out through the Consolidated Industrial and Commercial Tax (CICT) that had been introduced in 1958, and simplified in 1972. This was a turnover tax that was applied to industrial production, agricultural sales, imports, retailing, transport and communications and services. The 1958 regulations, however, continued to be applied to foreign enterprises and joir.t ventures. The principal tax instruments on international trade were customs duties that were levied on imports and export taxes on selected items. 4  - 2 - A,",AEX 1 Page 2 TIble 1. Chin State Budget Revenue, 1977-78 a/ (in billions of yuan) 1978 1979 1980 381 1982 1983 .84 '^'^ 1986 1987 1988 budget Tax .evenue b/ S2.0 53.8 57.2 63.1 70.0 86.9 106.8 2186 224.8 231.v