Source: www.asiaecon.org |

China's Reformed Tax Code: Striving For More Than Just Growth

Since the 1970s, China has sacrificed domestic growth for export growth through foreign investment. By the close of 2006 China had approved 594,000 foreign enterprises with a total investment in China of USD 691.9 billion.(1) Such sacrifices have rewarded China handsomely with consistently high GDP growth.

Since the 1970s, China has sacrificed domestic growth for export growth through foreign investment. By the close of 2006 China had approved 594,000 foreign enterprises with a total investment in China of USD 691.9 billion.1 Such sacrifices have rewarded China handsomely with consistently high GDP growth.

One of the catalysts that has driven such enormous volumes of foreign direct investment has been the dual income tax law, providing large tax concessions to foreign enterprises and putting domestic enterprises at a huge disadvantage. When China first opened up, the large tax advantages granted to foreign enterprises provided the necessary level of attraction to drive much needed foreign investment2. But domestic competitiveness, WTO compliance, corruption issues, and a dynamic socioeconomic environment have culminated in a recent transformation of the tax code that will level the playing field for domestic and foreign enterprises.

Problems Arising From Current Enterprise Tax Law

For years, the dual income tax system has heavily favored foreign investors to domestic ones, creating a disparity in tax burdens between the two classifications of enterprises. The average effective income tax burden for domestic enterprises is 25 percent versus 15 percent for foreign enterprises. When tax holidays and other incentives are added into the equation, the effective tax rate for foreign enterprises can been as low as 10 percent.3 Not only are domestic enterprises at a huge disadvantage; the government is as well. Such comparatively large concessions granted to foreign enterprises have meant a significant loss in government tax revenue, resulting in low revenue yields.

To add insult to injury, corrupt domestic enterprises gain foreign enterprise status by simply transferring funds, most notably to the British Virgin Islands where there are low corporate tax rates, and reinvesting the funds in China in order to take advantage of the “tax refund for reinvestment” law. Under this law, investors that put their money in a foreign enterprise are eligible to receive a 40 percent tax refund on the investment. This tax law has resulted in the British Virgin Islands’ status as the second largest source of foreign investment into China by 2006, with half of all registered companies in the British Virgin Islands being of mainland China origin.4 Such disproportionate tax rates have culminated in China’s placement as one of the ten worst business tax systems around the globe, as ranked by the World Bank.5

Enterprise Tax Reform

Beginning January 1, 2008, foreign enterprises will not have such an advantage. Nearly three decades after China started promoting foreign investment, political leadership has finally decided to take a step back, and in timely fashion as economic and social conditions have dramatically changed since dual taxation went into effect. A new enterprise income tax law, which was passed on March 16, 2007, and goes into effect on January 1, 2008, will begin to gradually phase in income tax increases for foreign enterprises. This will happen in an incremental fashion over five years, at which point the income tax rates offered to foreign and domestic enterprises will be unified at 25 percent. Foreign enterprises will not only face a 10% hike in their income taxes, but the elimination of other tax incentives like pre-tax reduction and tax refund for future re-investment. Still, the new income tax rate of 25 percent is comparatively low when weighed against global standards.6

In lieu of the recent G-8 Summit, it is encouraging to note that China has decided to keep tax incentives for foreign enterprises engaged in environmental protection. Other projects in which tax incentives will continue to be awarded are necessities such as agricultural development, water conservation, production safety, high-tech development and projects concerning public welfare. Small companies with low profits are eligible for a 5 percent tax break while high and new technology companies get a 10 percent tax break, signaling China’s continued advocacy of high technology and its benefits. China has moved away from wholesale concessions towards strategically targeted geographic areas and specific industries that are poised for growth. Minister of Finance Jin Renqing hails the tax reform as an “institutional innovation adapted to the new development of China’s socialist market economy and a subsidiary measure supporting the country’s sustainable development strategy.”

Implications of New Enterprise Tax Law

For many reasons this is a good policy. Indeed, a rapidly growing domestic market that has been fueled by higher levels of consumption, corruption directly linked to the enterprise tax laws, and China’s accession to the WTO has rendered such large concessions to foreign enterprises unnecessary and problematic. One of the main advantages to the new legislation is that it will provide a healthy boost in domestic competitiveness as a result of their reduced relative tax burden. The increased competitiveness in the domestic market will result in higher growth and ultimately increased profitability, resulting in even greater tax revenue for the government.

The reformed tax code should serve as a catalyst for greater scientific and technological advancement and cleaner environmental practices instead of a constant focus on back-breaking GDP growth that some experts say has caused or will cause an overheating of China’s economy. Indeed, multinational firms are already starting to respond to the new law with business strategies even though the law does not go into effect until the beginning of next year. General Electric China, for instance, recently announced a USD 50 million investment in their state-of-the-art technology center located in Shanghai that will fund environmental protection projects such as energy-saving light bulbs, wind power generators, seawater desalination technology, and airplane engines with higher efficiency. The new projects have been termed “eco-imagination” by Steve Bertamini, CEO of GE North East Asia who believes that China’s future lies in the business of being “green”.7

Many experts such as Liang Hong, chief economist for Goldman Sachs in China, and Joseph Lee, a tax and business advisory partner at Ernst & Young, believe that the 10 percent tax increase will not cause a slowdown in foreign investment. China’s immense market prospects, operational cost advantages and constantly improving business climate will continue to make China a favorable investment option.

Source: www.asiaecon.org |