Tax talk can make people squirm uncomfortably like a trip to the dentist. Chinese leaders, on the other hand, have a knack for tackling profoundly insipid topics, tax reform being one of them.
The country’s national tax regulator, the State Administration of Taxation, is knee-deep in pushing through the biggest change to the tax books in 20 years: Expanding value-added tax, or VAT. What happens next will have a huge impact on the solvency of financially troubled local governments.
VAT taxes the value a company adds to the original cost of materials, thereby preventing a double tax on the materials. It’s generally viewed as less burdensome than business tax, which until recently covered most of the service sector. State-run Xinhua News Agency estimated that the reform last year saved the included companies roughly US$15 billion.
It hasn’t always been clear which sectors are included, although regulators are making progress.
Last week, the annual National People’s Congress said it would expand VAT to the telecommunications sector in April. In December, the rail transportation and postal services were asked to pay VAT instead of the more burdensome business tax.
These announcements are building on a limited VAT pilot launched in 2012. The regulator took it national last August but many taxpayers found it difficult to figure out which kind of tax they needed to pay or how they would calculate it.
“It was really an experiment on a national level,” Xu Yan at the Chinese University of Hong Kong said of the trial. The incremental additions have helped clarify who’s in and who’s out. Many sectors in the service industry have been left off the list for now, including real estate, construction, financial services and insurance. In time, tax authorities will try to incorporate these into the VAT system but calculating the tax on sectors such as finance is difficult and will take time.
The Chinese government could be applauded for pushing along so swiftly with this onerous – and monotonous – reform. But before officials get too carried with the scale of VAT, they’ll need to make sure the new tax policy doesn’t impoverish already struggling local governments.
China adopted VAT in 1994, when the country last drastically shook up the way its economy worked. That year, China levied VAT on most goods but stopped there. The economy was focused on exporting and VAT was a break to the manufacturers that were fueling economic growth. Meanwhile, China’s services industry was infantile and regulators lacked the technical capabilities to include it.
Local governments largely lost out that year. The new law gave the central government 75% of revenues from VAT just as provincial and municipal governments were thrown new responsibilities such as pensions and lost the ability to borrow directly from banks to help pay for it.
Governments in manufacturing hubs stood to lose the most, as the central governments swallowed up the vast majority of tax revenues from the goods produced in those areas.
The balance sheets of local governments have deteriorated since then, particularly in the past three years. A nationwide audit released at the end of 2013 showed that local government debt had surged 67% since 2010, leaving some provinces in dire financial shape.
Without a renegotiation of the way local and central governments share tax revenue, further VAT reform could distress the balance sheets of local authorities even more. If the terms on tax collection are not adjusted, local governments will get a smaller and smaller piece of the pie as both the service industry and VAT expand.
“This could happen,” Xu warned. “Currently the central government still uses the previous sharing regime for the revenues from the pilot reform … There must be some negotiation.”
China’s service sector is growing rapidly. In 2013, GDP generated by services exceeded that of industry and manufacturing for the first time. That’s a good thing for China, showing that the country is indeed moving away from exports and turning to domestic services to power the economy. But local governments will need a better cut of these returns on growth if they are expected to stay financially sound.
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