Rebate reaction

Xinhua news agency announced on October 13 that Beijing would cut the rate of VAT rebate on exported goods, a measure intended to kill several birds with one stone. The rapid growth of China's exports is widely blamed for the loss of manufacturing jobs in the US, and a cut in VAT rebates would go at least some way towards meeting Washington's demands for an appreciation of the yuan. Given widespread signs that the Chinese economy is overheating, a modest slowdown in export growth might also help cool an unsustainable boom in demand. Moreover, scaling back the rebate scheme would strengthen the central government's fiscal position, reducing a budget deficit that reached 3 per cent of GDP in 2002.

Reports in early October had suggested that VAT rebates for exporters might be cut by 4 percentage points from the current average of around 15 per cent. However, a joint circular issued by the Finance Ministry and the State Administration of Taxation showed that the plan offered less than met the eye. Along with its two-tiered VAT regime, which taxes 'essential' goods at 13 per cent and most others at 17 per cent, Beijing will now apply no fewer than six levels of VAT rebate to exporters. Most goods taxable at 17 per cent will now be rebated at 13 per cent, while those taxable at 13 per cent will qualify for 11 per cent rebates. But favoured exports, such as automobiles, aircraft, and integrated circuits, will still receive a full 17 per cent rebate, while most industrial raw materials will qualify for lower bands of 8 per cent, 5 per cent or zero.

Although exempting exports from value-added tax is standard international practice, China has only recently come close to rebating exporters' VAT in full. Until mid-1999, official rebate rates were well below actual VAT paid, imposing an effective tax on the export sector. In the

wake of the Asian financial crisis, which saw China's export growth collapse in 1998, the rebate schedule was revised, with most products eligible for rebates at 13 per cent, 15 per cent or 17 per cent. This brought the theoretical tax burden on most exports close to zero but, in practice,VAT refunds have been treated as a budgeted expenditure rather than an entitlement, and payment delays have been widespread. The State Council's Development and Research Centre estimates that outstanding rebate arrears in mid-2003 were nearly Yn250bn, or over 2 per cent of GDP.

Standardisation of rebate system
The latest announcement promises a standardisation of the rebate system, with lower rebate rates in exchange for prompt payment and the clearance of arrears. It also pledges, somewhat cryptically, that 'increases in central import duties will be used on export tax rebates'. This appears to endorse a proposal floated earlier: that some portion of the VAT payable on imports – which grew by more than 40 per cent year-on-year in the January- September period – will be earmarked to fund rebates on exports, which have grown somewhat more slowly over the same period.

For these reasons, the rebate cuts look attractive in principle. A de facto tax on exports would distort production incentives in most economies, but in China's case it may simply offset the opposing distortion caused by the weak yuan peg – and in any case, efficiency losses from the arbitrariness of the current refund system may be even greater. By serving as a partial substitute for revaluation, lower VAT rebates may also check the influx of 'hot money' from speculators betting on a rise in the yuan. If this reduces the central bank's need to intervene to keep the yuan down, it could undermine US criticism of China's currency peg.

But the increased graduation of the new refund scheme may leave Beijing's trading partners uneasy, since it seems to give effective protection to China's manufacturing sector. Rebates have been cut to zero for a range of non-ferrous metals, such as tungsten and rare earths, for which China dominates global output. On theoretical grounds this makes perfect sense, since it shifts part of the tax burden to foreign buyers. Less justifiably, rebates for energy exports have been reduced to help meet China's growing demand. Most petroleum products will no longer qualify for VAT rebate, and the refund rate on coke and soft coal has been cut to 5 per cent.

This amounts to a regime of differential export taxes, which would be distortionary but is not specifically prohibited by current World Trade Organisation rules. However, the US government is known to support bringing such policies under multilateral discipline. Claiming that Latin American nations support their domestic oilseed-crushing sectors by taxing raw oilseed exports, Washington has sought to ban differential export taxes under the proposed Free Trade Agreement of the Americas. The WTO itself has also suggested that similar policies may delay Russia's accession to the body, since controls on oil and gas exports subsidise the industrial sector by lowering domestic energy prices.

Chinese uncertainty about the US response to a graduated VAT rebate scheme may explain why details of the proposal were so slow to emerge. Much of the recent criticism of China has come from the beleaguered US textile and apparel sectors, where Beijing is subject to special 'safeguard' provisions that will allow its trading partners to restrict Chinese imports even after the general elimination of textile quotas at end-2004. Since the safeguard rules represent China's point of greatest vulnerability to overseas pressure, a rebate schedule that favours manufacturers over exporters of raw materials may do little to cool the protectionist fever in Washington – and might even intensify it.