metadata: authors: 0: author: Heady, Christopher J.
1: author: Mitra, Pradeep K.
count: China
docna: 0: docna: Taxation in decentralizing socialist
            economies : the case of China
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Oil Refining & Gas Industry,Public Sector Economics,Energy Policies & Economics,Competition Policy,Competitiveness and Competition Policy,Public Finance Decentralization and
            Poverty Reduction,Transport Services
teratopic: International Economics and Trade
abstracts: cdata!: The authors analyze the tax system in
            China, where reforms designed to move the economic system
            toward a market economy have been occurring for more than a
            decade.  The authors characterize the comprehensive changes
            in the tax system that could be undertaken in the presence
            of system-wide reform, especially of prices and enterprises,
            as well as of more moderate reforms that must suffice in the
            absence of reforms elsewhere in the economic system.  In
            connection with tax reform per se, they emphasize that it is
            possible to simplify significantly the rate structure for
            indirect taxes in the presence of price controls, but a
            unified rate for value-added tax is undesirable without full
            decontrol of prices.  They also found that the state's
            role as owner of enterprises must be treated separately from
            its role as tax collector.  All enterprises should pay
            statutory profits taxes.  Negotiation (of the kind that
            characterizes the contract responsibility system) should be
            confined to the payments to government from after-tax
            profits.  Those payments could be set to balance incentives
            to enterprises with the need for the state to earn a return
            on assets historically provided free to those enterprises.
            The mode of analysis developed in this paper can be applied
            to a wider range of economies - whether emerging from a
            socialist past or not - that are progressing at varying
            speeds in the interlinked areas of tax reform, price reform,
            and enterprise reform.
geo_reg_key: 517198,119225,517191
repnme: repnme: Taxation in decentralizing socialist
            economies : the case of China
display_title: Taxation in decentralizing socialist
            economies : the case of China
listing_relative_url: /research/1992/01/699802/taxation-decentralizing-socialist-economies-case-china
topicv3: Price Controls m1326085 2107,Transport m1326661 135,Power and Electricity Sector m1327094 515,Taxation m1327615 1121,Petroleum Industry m1583790 4710
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: South Asia: Country Department I
no_of_pages: 38
model_extractions: **Policy Research**

# **Country Operations**

WPS 820 This papera product of the Country Operations Division, Country Department **_'_** Asia Regional Office -- is part of a larger Asia Region/PRE study on revenuc mobilization in China. Copies are available free from the World Bank, 181 8 H Street NW, Washington DC 20433. Please contact Dakshi Sebastian, room D9-1 1, extension 8(A23 (33 pages). Januarl 1992.

Heady and Mitra analyze the tax system in China, where reforrns designed to move the economic svstem toward a market econom) have been occurring for more than a decade.

Heady and Mitra characterize the comprehensive changes in the tax system that could be undertaken in the presence of systcmwide reform, especially of prices and entcrprises, as w,ell as of more moderate relforms that must suffice in the absence of reforms elsevwhere in the economic system. In connection with tax reform per se, they emphasize two important conclusions:

- It is possible to simplify signiiificantly the rate structure for indirect taxes in the presence of' price controls, but a unitied rate for value-added tax is undesirable without full decontrol of prices.

> * The state's role as owner of enterprises must be treatcd separatcly from its role as tax collector. All enterprises should pa) statutory profits taxes. Negotiation (of the kind that characterizes the contract responsibility system) should be confined to the payments to govemment from after-tax profits. Those payments could be set to balance incentives to enterprises with the need for the state to earm a return on assaes historically provided free to those enterpnisec.

'Tle modie of analysis that Heady and Mitra develop in this paper can be applied to a wider range of economies --- whether emerging from a - socialist past or not that are progressing at varying speeds in ithe interlinked areas of tax reform, price relor-ni, antd enterprise reform.

The lPohic Research Working Plqer Series ii di,enntn.te the I intdi,g'\ ol ss,rk under A **\** irIn the Bank An **ohbecti%** e of **thc** series i to gel these findings **iut** qui .Ki_ . even if presentations are less th.n _[(Li_ posk hd The findinFs., iterpretations, and Lonclusioris in these **papers** do noi neiessr,srik epre.ent **ofilnii** Hank pollk

> Pr0dLJe(d h! die _IC 011_ Re wsar hi Disse **iknina.t ion (enltvr**
# Taxation in Decentralizing Socialist Economies: The Case of China

by Christopher J. Heady University of Bath

# and

Pradeep K Mitra World Bank

# Table of Contents

1. Introduetion

2. Indirect Taxes

|2.1 The Current Tax Structure<br>|
|---|
|2.2 Taxes and Enterprise Profitability<br>|
|2.3 Simplification of the Rate Structure<br>|
|2.4 Tax Simplification<br>|
|2.5 Cascading<br>|
|2.6 Equity<br>|
|2.7 Price Controls as Implicit Taxes|

3. Direct Taxes 1 2 2 8 9 11 12 14 16 19

- 3.1 The System of Enterprise Income Tax 3.2 Contract Responsibility System

- 3.3 Problems with the Current System

- 3.4 Statutory and Effective Rates of Tax 3.5 Resource Tax

_19_ 21 23 24 29 4. Conclusions 30

|References|
|---|

33

> * The analysis of this paper was undertaken as part of a World Bank study on revenue mobilization in China. We thank Patrick Honohan and Christine Wallich for their helpful comments on an earlier draft.
1

## i. INTRODUCTION

# Scope

China has been gradually reforming its economic system towards that of a market economy over the last ten years. That process has, inter alia, necessitated a restructuring of the system of taxation. It is the principal task of this paper to describe the tax system, to analyze its economic consequences and to highlight the close relationship between further tax reform and other reforms, most notably those in the price system and the management of State enterprises. A secondary task is to study the Chinese experience with a view to eliciting lessons for other countries that are currently moving towards a free market system.

China's tax system has several features in common with those of the emerging market economies of Central and Eastern Europe. As far as indirect taxes are concerned, the nominal burden falls on enterprises rather than consumers, and there are large numbers of different rates. Direct taxes are also complex in part because they are mainly levied on e.aterprises whose close relationship with the State makes the application of uniform tax rules difficult to operate but also because numerous anomalies in the tax system introduce significant and unfcrseen distortions in the incentives for investments. These characteristics of the tax system have led to difficulties as the free market has expanded in China. The lessons from these difficulties should help other countries in reforming their tax systems to meet the requirements of a market economy.

Notwithstanding these similarities, the gradual nature of reform in China means that its experience must be regarded as somewhat special when compared to the emerging market economies of Central and Eastern Europe. None of the latter is characterized, for example, by the coexistence of free market prices and controlled prices for the same goods (the "dual pricing system"). For this reason a number of important policy issues raised by the dual pricing system and discussed in this paper are not applicable to those economies. They may however find application in a range of developing countries, whether or not emerging from a socialist past, that are attempting to reform interlinked systems of administered prices and taxes.

# Reforms

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 enterprises, 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 over 90 percent of profitable state enterprises adopting profit retention.
2 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. It was replaced in 1984 by the Product Tax, VAT and Business Tax. The CICT however continues to apply to foreign enterprises and joint ventures.

# Plan of the paper

Section 2, following this introduction, provides a detailed analysis of the structure and reform of indirect taxes in China. Section 3 of the paper is concerned with direct taxes. Section 4 concludes by drawing together the main issues and considering their implications for other de_entralizing socialist economies in transition.

# 2. INDIRECT TAXES

# 2.1 The Current Tax Structure

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. 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, and it is on those taxes that this paper concentrates.-" The system of price controls is an implicit subsidy to users, financed by an implicit tax<sup>on</sup> producers. Hence price controls on final goods subsidize final consumers at the expense of consumer goods-producing enterprises, while price controls on intermediate goods boost profitability in consumer goods producing enterprises at the expense of those producing intermediate goods. Since indirect taxes must operate within the overall framew,rk of price controls, it is desirable to view taxes and price controls as cone W-uting an integrated system. This perspective is more fully developed in ! tion 2.7.

# Product Tax

Product tax is levied on the manufacture and import of certain<sup>goods.</sup> Goods are valued (for tax purposes) at the price paid by purchasers. This differs from normal international practice, where tax rates are expressed as a percentage of the producer price. It means that, with controlled prices,<sup>taxes</sup> reduce the revenue received by the enterprise and do not increase the prices paid by the consumer.

V The tax system, and its evolution, are described in more<sup>detail in Easson</sup> and Li (1987). A general analysis of its strengths and weaknesses,<sup>including</sup> recommendations for reform, are given in World Bank (1990).
**3**

This distinction is also important in interpreting the tax rates on major categories of goods, presented in Table 2.1. To take an example, one of tne tobacco products is grade A cigarettes, with a product tax rate of 60 percent. This means that ror every 100 Yuan spent by consumers on this product, 60 Yuan is paid in tax and 40 Yuan is received by producers. Thus, the tax paid is 150 percent of the producer price. In other words, the 60 percent product tax is equivalent to a sales tax (defined by normal practice) of 150 percent.

Table 2.1 shows that there is substantial variation in tax rates. This is a common feature of tax systems in socialist economies, such as Czechoslovakia and the Soviet Union, but it constitutes a major diff,trence between the Chinese tax system of indirect taxes and the systems in use in market economies. Nonetheless, the structure of rates shows certain similarities with the structure of indirect taxes in other countries. For example, the application of especially high rates of tax to tobacco products, alcoholic beverages and gasoline is virtually universal practice. Taxes on these three groups raised approximately 27 percent of total Product Tax revenue in 1986.

# Value Added TaxV

Value Added Tax (VAT) is gradually replacing Product Tax as the major indirect tax on manufacturing and imports. The replacement is carried out in such a way that while both .axes cover all manufactured goods, no product is simultaneously liable to both. VAT rates have also been decided on a product-by-product basis with rates set to yield the same revenue as the former Product Tax (although there are some goods, such as textiles, that have seen a reduction in their tax burden). This means that there is also a large number of VAT rates. The current range of goods subject to VAT is indicated by Table 2.2, which also shows the rates. VAT is not applied to agriculture, services, construction, transport and communications or wholesale and retail distribution. In keeping with general international practice, exports are zero-rated.

As with Product TPx, VAT is applied to the purchase price of a good, not its producer price. The difference from Product Tax is that taxes paid on intermediate inputs into production are credited and so reduce the tax liability. The nominal rates of tax are therefore increased when goods are switched from Product Tax to VAT, in order to maintain revenue and prevent excess profits.

The coexistence of Product Tax and Value Added Tax is unusual, as is the large number of different rates. Both features are administratively costly. First, it is difficult to calculate the tax that should be credited for intermediate inputs, some of which have paid Product Tax and others VAT at typically different rates. Second, the above difficulty is compounded by the fact that invoices do not show the amount of tax paid.

For a discussion of different variants of the value added tax, see Shoup (1990).
4

# TABLE 2.1

# Froduct Tax Rates on Major Product Groups

# May 1988

|Product Group|Rat|es|
|---|---|---|
|Tobacco Products|35Z|<br>60Z|
|Beers, Wines and Spirits|10%|- 50Z|
|Rubber Products|10%|- 202|
|Building Materials|3%|- _1zZ_|
|Minerals|**32**|-<br>12%|
|Electric Power|5Z|-<br>252|
|Gas|3%|-<br>15%|
|Gasoline||4|
|Diesel||10o|
|Kerosene||25%|
|Other Petroleum Products|3%|-<br>35Z|
|Chemicals|3Z|- 25z|
|Metals|3%|-<br>15X|
|Tea|102|- 25X|
|Luxury Foods|5%|- 357|
|Timber, Bamboo and Lacquer|5b|-<br>15Z|
|Meat||3Z|

Source: General Taxation Bureau In principle, the VAT should credit enterprises for both the product tax and the VAT that has been paid on purchased intermediate inputs. However, in practice, the credit for inputs that have Daid Product Tax is made at a composite rate of 14 percent. For some enterprises this composite rate is extended to include all intermediate inputs, including those that have paid VAT. This practice is administratively attractive when firms purchase a range of inputs that have paid VAT at different rates. The operation of the Chinese VAT is therefore one of "presumptive" crediting and thus differs from the standard invoice method.

VAT in China does not allow credit for tax paid on purchases of fixed assets. Such discrimination against investment goods makes the tax income-based in contrast to the consumption-type VAT that appears on the statute books of many countries.
5

# TABLE 2.2

# Value Added Tix Rates on Major Product Groups

May 1988

|Product Group|Rat|es|
|---|---|---|
|Textiles|14Z|-<br>232|
|Clothing and Footwear|14Z|- 202|
|Enamel Products||202|
|Glass and Glass Products|142|-<br>26Z|
|Medicines||14Z|
|Household Machinery|14%|-<br>43Z|
|Electrical Appliances|14%|-<br>20X|
|Electronic Appliances|142|-<br>16Z|
|Machinery|12%|-<br>14Z|
|Steel||8Z|
|Steel Products||14X|
|Paper|142|-<br>302|
|Stationery|122|-<br>302|
|HouseholdChemicals|142|-<br>452|
|Ceramics|122|-<br>202|
|Processed Food and Beverages|14X|-<br>302|
|Leather|142|-<br>202|
|Furniture||142|

Source: General Taxation Bureau

# Business Tax

The Business Tax replaced that part of the Consolidated Industrial and Commercial Tax that applied to wholesale and retail distribution, construction, transport and communications and services. It is applied to non-agricultural activities outside manufacturing: retail, wholesale, transport, construction, banking and insurance, telephones and telecommunications, publishing, utilities, entertainment and other services. It is a turnover tax on gross sales value in all sectors except wholesale where it is levied on the gross value of the mark-up. The rate structure is shown in Table 2.3.
6

# TABLE 2.3

# Rates of Business Tax

# May 1988

|Industry|Tax Rates|
|---|---|
|Retail<br>|3Z|
|Who'lesale|lOZ|
|Transport<br>|3Z-<br>15X|
|Construction<br>|3Z|
|Banking and Insurance|5%|
|Telephone; and Telecommunications<br>|3Z|
|Publishing<br>|3Z|
|Utilities<br>|3Z|
|Entertainment<br>|3Z|
|Other Services|3X-<br>10%|

Note: Tax is levied on gross sales value, except for wholesale where it is levied on gross mark-up.

Source: General Taxation Bureau

# The Rate Structure: Historical Rationale

The highly differentiated tax rate structure is a consequence of the change in 1983 from profit remittance to profit taxacion for state-owned enterprises. Under the profit remittance system that prevailed up to 1983, the fact that state-controlled prices did not reflect costs of production was not of any particular significance. However, under profit taxation, enterprises are allowed to retain a certain proportiorn of their profits, so that the pricing system has the potential for generating considerable inequality between enterprises, with attendant consequences on their investment and growth prospects. As the price of a good to its purchaser was fixed by the State, the product tax rate could be set to reduce the price received by the producer and thus reduce excess profits. Indeed the main consideration in setting product tax rates in 1984 was to equalize profits (as a proportion of sales value) across sectors, but with modifications to encourage or discourage the production of particular goods. It is this which explains the large number of different product tax rates and, in cases where they were subsequently replaced, of VAT rates.

In principle, prices could have been adjusted to equalise profitability between industries. However, the government has been unwilling to undertake a thorough revision of prices, and price changes have been confined to a fairly small number of goods. Instead, the use of taxation rather than price reform has been seen as being politically more acceptable.
7 The fact that differential indirect taxes are used to equalize profits is further illustrated by the fact that the product tax rates on cement, crude o.l and electricity also depend on the size of the producing cnterprises. Thus larger enterprises in the cement industry pay 10 percent Product Tax while smaller enterprises pay 5 percent.

As well as equalising profitability, some dom-stic indirect taxes are partly set with reference to considerations of industrial policy. For example, the recent switch of the textile industry from Product Tax co VAT was accompanied by a reduction in the industry's overall tax burden, apparentlv with the aim of promoting the industry.

The use of taxes to encourage or discou:..age particular industries can be quite effective in an economy with limited foreign trade, althougn direct subsidies would be an economically more cost-effective policy. However, as China's foreign trade expands, the effects of taxes will change. First, the possibility of foreign trade means that domestic production and consumption of particular goods need not be equal and so a distinction can be drawn between the aim of discouraging consumption and that of discouraging production. In the case of cigarettes, it is probable that the authorities' aim would be to discourage consumption (there is no obvious need to reduce production so long as increased production reduces imports or increases exports) and increased taxes with fixed consumer prices will not reduce consumption. Second, changes in taxes will no longer have such a large effect on domestic production because a tax change that alters incentives for domestic producers will also alter incentives for importers. Thus, a tax reduction will stimulate imports as well as domestic production. In these circumstances, direct subsidies become a more effective method of promoting particular industries.

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 output on the free market. At the same time enterprises may buy a certain quota of inputs at list prices. The proportion of consumer goods transacted at list prices had fallen from 97 percent in 1978 to 47 percent in 1986. By 1986, the proportion of intermediate goods sold at list prices had fallen to 60Z.

Indirect tax rates in China were therefore designed for a fixed price economy, but row operate in an economy with both fixed and flexible prices. The effects of tax changes are however very different on plan transactions and free market sales. A tax increase will reduce enterprise profitability on sales at fixed prices but will not distort consumer choice. However, a **tax** increase on free market sales will mainly be passed on to final consumers, unless the supply of the good is unresponsive to price changes, and the differentiated tax structure will have adverse incentivt effects.

Of course, some differentiation of the tax structure is desirable **ever.** in a market economy for several reasons: (i) to discourage the consumption of socially harmful goods, (ii) to tax luxury goods that are consumed very heavily by the rich, (iii) to tax goods with price-inelastic demands so as to
8 allow revenue to be raised in an efficient way. However,<sup>the differentiation</sup> required on the above grounds bears little relationship with that stt by the tax authorities to equalize sectoral profitability. In any<sup>event, the</sup> efficiency objective of distortionary taxation can<sup>usually be achieved in</sup> practice by setting particularly high tax rates on a small<sup>number of</sup> particular goods, rather than by highly differentiated<sup>taxes across the whole</sup> range of industrib± products. Excessive sectoral differentiation in China has negative incentive effects that depend, inter alia, on<sup>the proportion of sales</sup> transacted at market prices.

# 2.2 Taxes and Enterprise Profitability

As stated above, the General Taxation Bureau sets<sup>VAT and Product Tax</sup> Rates in order to generate producer prices (i.e.,<sup>plan prices less taxes) that</sup> allow enterprises to earn "reasonable" profits, subject to additional considerations of industrial policy.

The 1984 tax reforms set indirect cax rates to equalize profitability<sup>on</sup> sales across sectors to the profit margins prevailing<sup>in 1983. This may be</sup> seen as a substitute for the tendency towards equalization<sup>of returns on</sup> equity that characterizes market economies. However, profitability on sales that forms the basis for tax policy bears little relationship with profitability on assets, which one expects to be equalised in a competitive market economy. And the two notions are noticeably different in r,iany industries. Thus, in ferrous metals, mining and preparation,<sup>profits and taxes</sup> in relation to Rmib 100 of sales revenue are, at 20.27,<sup>well above the national</sup> average of 9.79, making that industry a candidate for heavy indirect taxation. In contrast, profits and taxes in relation to Rmb 100<sup>of the original value of</sup> fixed assets, at 12.65, are below the national average<sup>of 109.00 so that</sup> taxes, if set with reference to the latter measure of profitability, would be relative low in that industry.

The measure of profitability that currently guides the<sup>setting of</sup> indirect tax rates is particularly problematic when consideration<sup>is given to</sup> the principal uses to which after-tax profits in State-owned<sup>enterprises are</sup> put. "nese are broadly speaking, of two kinds: (1) investment<sup>in expansion of</sup> the enterprise, and (2) provision of bonuses and other 'anefits to workers. While an enterprise's need for funds under<sup>(1) depends on its capital-</sup> intensity and rate of growth, its needs under (2) depend<sup>on the number of</sup> workers. Given that retained earnings accounted for 38<sup>percent of investment</sup> in fixec. dssets in 1986, this has meant that equalizing sales<sup>profitability</sup> could starve capital-intensive industries of funds for expansion. This was particularly marked in railways and electricity. Hence the Business Tax on railways was reduced in 1986 and th- ax rules<sup>for electricity altered to</sup> allow a e costs to be deducted for tax purposes. By the same<sup>token,</sup> l1'-our-ilitensive industries have found it more difficult to afford bonuses thai. less labour-intensive industries.

The issue of enterprise profitability is important in any decision to simplify the tax rate structure, as discussed in :he next section.
9

# 2.3 Simplification of the Rate Structu-.

When confronting such **d** high.y differentiated tax rate structure, it is natural tn azk what the consequences of its simplifi_ation would be. This section therefore calculates what the rates of tax would be if the same r-venue was raised with a uniform VAT, supplemented by excise duties on tobacco, alcohol and petroleum products. It also illustrates the effect o. this simplification on enterprise profitability by considering the case of the Rubber Products industry. It will be assumed that the change in tax rates has no effect on the output or value added in any industry. Under this assumption, the calculation of the necessary VAT rate involves the estimation of the revenue requirement and the tax base: the rate is then obtained by dividing the first figure by the second.

The total "resources of revenue" from Product Tax and VAT in 1986 was approximately Rmb 86 billion, including taxes collected on imports. However, it appears that this figure does not take account of refunds to enterprises when goods are exported and hence exceeds the net sum collected. No data, however, are available on the exter of the difference. Of the Rmb 86 billion, approximately Rmb 20 billion is obLained from the Product Tax on tobacco, alcohol and petroleum products. The revenue requirement from other goods is therefore Rmb 66 billion.

The tax base from which this revenue will be collected under VAT consists of industrial value added (excluding tobacco, alcohol and petroleum products), plus imports and industrial purchases of agricultural products, since the latter are tax-exempt and cannot be deducted from enterprises' liability to VAT. Some of this revenue will have to be refunded to exporters of manufactured products. It is tempting to ignore those refunds as the revenue requirement appears to disregard them. However, the introduction of a uniform VAT can be expected to improve the efficiency of the refund system and might well increase total refunds. For this reason, the subsequent exercise produces two estimates of the VAT rate: one where exports are not subtracted from the tax base and another where manufactured exports are subtracted from the tax base. The first calculation therefore makes the assumption that there will be no increase in VAT refunds while the second assumes that the current level of refunds is only a small proportion of those that would arise from a uniform VAT. The first will underestimate the necessary rate, while the second will overestimate it.

In 1986, industrial value added was Rmb 334 billion, of which approximately Rmb 32 billion was generated in the tobacco, alcohol and processed oil industries.Y Value added in other industries was therefore Rmb 302 billion. Farm and sideline product sales to industrial and other departments was Rmb 37 billion and imports were Rmb 150 billion. The base of the VAT (disregarding export refunds) is therefore approximately Rmb 489 = billion. The tax rate needed to raise Rmb 66 billion is thus roughly 66/489 13.5 percent.

3/ The Chinese carrency is called Renminbi (RMB). It is denominated in Yuan (Y). In calendar 1988, Y1.00 = US$0.27.
10 Turning to the second calculation, it is necessary to subtract approximately 85 percent4' of export value, which equals Rmb<sup>92 billion. The</sup> tax base then becomes Rmb 397 billion and the necessary<sup>tax rate is 66/397=</sup> 16.6 percent approximately.

These two estimates represent the upper and lower bounds on<sup>plausible</sup> VAT rates and it is not unreasonable to take an intermediate<sup>figure of 15</sup> percent as representing the "best guess". This is broadly<sup>consistent with the</sup> current approach used by the General Taxation Bureau in setting<sup>VAT rate' 14</sup> percent is taken as a standard rate that is used most often,<sup>although</sup> substantial deviations from this figure are used in particular<sup>circumstances.</sup> Upward deviations from this figure are the most frequent, and<sup>this is</sup> consistent with the fact that 14 percent is very near the<sup>lower end of the</sup> range calculated above.

To see how a uniform rate of VAT at 15 percent can be supplemented<sup>by</sup> excise taxes, consider the case of the tobacco industry. This<sup>example is only</sup> an illustration of the principles involved as it neglects<sup>untaxed inputs into</sup> tobacco manufacturing and assumes that all tobacco products<sup>are taxed at the</sup> same rate. fhe value added in this industry is approximately<sup>Rmb 14 billion,</sup> so that a 15 percent VAT would raise Rmb 2.1 billirn. This contrasts with the Rmb 11.3 billion currently collected from the proauct tax.<sup>Maintenan,ce of the</sup> current total tax receipts from the tobacco industry would<sup>therefore require a</sup> supplementary excise tax that would raise Rmb 9.2 billion.<sup>Such a tax would</sup> be based on the total output of the industry, Rmb 17.2 billion.<sup>The excise tax</sup> rate would therefore be 92/172 = 53 percent. Similarly, turning<sup>to petroleum</sup> products, value added equals Rmb 12.83 bi.llion, so that a 15 percent<sup>VAT would</sup> raise Rmb 1.93 billion. Since total output is Rmb 23.37, maintenance<sup>of the</sup> existing tax receipts of Rmb 5.67 billion would require<sup>an excise tax rate of</sup> 16 percent.

The effect of unifying the VAT rate on enterprise profitability may be illustrated using the following example based on the rubber<sup>products industry.</sup> In 1986, the tax revenue from rubber products was approximately Rmb<sup>1.634</sup> billion. The unification of VAT discussed above would lead to a rate<sup>of 15</sup> percent, which would have yielded Rmb 0.758 billion (on a<sup>1986 value added of</sup> Rmb 5.05 billion).

The effect of this tax reduction on profitability in the rubber products industry will depend on the degree of price control<sup>to which the industry is</sup> subject. Assume first that all output is subject to price control.<sup>In that</sup> case, enterprises in the industry increase their income<sup>by Rmb 0.876 billion.</sup> Taking the current rate of enterprise income tax, 55<sup>percent, after-tax</sup> profits will rise by Rmb 0.394 billion. A perspective on this<sup>figure is</sup> provided by comparing it with the industry wage bill of<sup>approximately Rmb</sup> 1.857 billion (value added minus Rmb 3.293 billion of profits<sup>and taxes).</sup> Thus, for example, if all extra profits were paid as bonuses,<sup>they would</sup> amount to 21 percent of the wage bill.

9 As the average rate of VAT is approximately 152, the 85 percent<sup>ofexport</sup> **value** represents the factor cost of the exports.
11 This result under price control may be compared with what would happen with no price controls. In this case, the increase in profitability will encourage enterprises to lower prices in order to capture a larger share of the market. If the industry is competitive and there is no shortage of supply, prices will fall until the level of profitability is the same as before. Total profits will rise if output increases in response to the increased demand generated by lower prices, but profits per unit of sales would continue to be the same.

It is not known what proportion of rubber products are sold on the free market. Suppose, in line with the average situation for intermediate goods, that the figure is 60 percent for plan sales and 40 percent for sales at market prices. In this case, the reduction in taxes will, as before, increase the profitability of production. Since enterprises can sell additional output at free market prices, they will cut those prices as in the case of no price controls. Thus the free market price will fall by as much as before, so long as there is sufficient competition and there will be no increase in profits per unit of sale on goods sold on the free market. The effect on profitability is then confined to the output that is sold at fixed prices. As this is 60 percent of sales revenue, the profit increase is 60 percent of that available when all the product was sold at fixed prices.

This analysis could equally well be applied to an industry that would suffer an increase in taxation following attempts to unify the VAT. In such a case, the reduction in profitability will depend on the proportion of output that is sold at fixed prices. In general, the effects of tax changes on profitability will be smaller for industries that sell high proportions of output at free market prices.

# 2.4 Tax simplification

The discussion in section 2.3 suggests that there would be considerable gains and losses for enterprises in different industries as a result of complete simplification of indirect taxes. These gains and losses would create inequality in wage bonuses and in access to investment funds (which would, in turn, increase future inequality in wage bonuses). This is an example of a trade-off between equity and efficiency: uniform taxes promote efficiency but, in these institutional circumstances, create inequality. Such a trade-off can be analyzed using optimal tax theory and this is presented in Heady and Mitra (1991), where an analytical framework is developed and illustrative optimal taxes are calculated.

Such optimal taxes are highly differentiated if the administrative costs of taxation are ignored. However, in view of the considerable difficulties of administering a highly differentiated tax structure it is worth asking whether limited tax simplification might allow most of the advantages of differentiated taxation without excessive administrative cost. To this end, tables 2.4 and 2.5 present the results of allocating goods into three tax groups and calculating the optimal tax rate for each group. The groups were chosen by calculating optimal taxes for each of the 24 goods, and grouping together goods with similar tax rates. In addition to
12 presenting the optimal tax rates,<sup>tables 2.4 and 2.5 present the welfare</sup> loss from imposing completely uniform<sup>taxation and the welfare gain from</sup> setting each good's tax rate separately<sup>(unrestricted taxes). The welfare</sup> gains and losses are measured<sup>in GDP equivalents.</sup> Table 2.4 reports the optimal taxes<sup>and welfare losses for varying</sup> proportions of the output of each<sup>industry being sold at plan prices, holding</sup> the degree of inequality aversion,<sup>e, equal to zero (implying that twice as</sup> much weight is put on income gains<sup>to individuals with half the income). Table</sup> 2.5 holds the proportion subject<sup>to plan prices constant, and illustrates the</sup> effects of changing e from unity<sup>(no inequality aversion) to minus ten (very</sup> high inequality aversion).

The results show an increased<sup>spread of tax rates as either the</sup> extent of planning or the degree<sup>of inequality aversion increases. The role of</sup> the extent of planning follows<sup>from the fact, illustrated in section 2.3, that</sup> the effect of tax changes on profitability<sup>depends on the extent of price</sup> control. The role of inequality<sup>aversion reflects the fact that more</sup> efficiency will be sacrificed if<sup>the removal of inequality is given higher</sup> priority. The losses from uniform<sup>taxation and the gains from</sup> unrestricted taxation increase<sup>similarly. However, in all but one case, the</sup> loss from imposing uniformity<sup>is more than twice the gain from allowing</sup> unrestricted taxation.

Thus, the introduction of three<sup>separate tax rates captures at</sup> least two-thirds of the gains<sup>that would be made in moving from uniform</sup> taxation to unrestricted taxation.<sup>The analysis makes clear that reducing</sup> the number of VAT rates without,<sup>however, moving to unification,</sup> would lead to significant welfare gains while<sup>permitting greater efficiency in tax</sup> administration.

# 2.5 Cascading

As in many developing countries,<sup>the indirect tax system derives a</sup> significant amount of revenue<sup>from the taxation of raw materials and capital</sup> goods entering the production process.<sup>To the extent that enterprises</sup> increasingly choose techniques<sup>of production, the taxation of such goods is</sup> distortionary and detracts from<sup>efficiency in production. By adding to the</sup> costs of production, it also<sup>increases the cost of exports, adversely</sup> affecting China's competitive position.<sup>The gradual replacement of Product Tax</sup> by VAT is designed to address these<sup>problems. However, inasmuch as the VAT,</sup> though growing in coverage,<sup>is still partial, allowance is not made for taxes</sup> paid on all inputs. For these reasons,<sup>the full tax burden borne by a</sup> commodity does not consist simply<sup>of the tax applied to final output. It also</sup> includes the taxes paid on<sup>inputs, and on the inputs used in producing the</sup> inputs all the way back through<sup>the process of production.</sup>
13 TABLE 2.4 The Effect of Planning n Tax Rates Degree of inequality aversion, e = 0

|Tax Group|1/4 Plan|1/2 Plan|3/4 Plan|
|---|---|---|---|
|Low|41?|28Z|21Z|
|Medium|46Z|45Z|42Z|
|High|75Z|76Z|67Z|
|Welfare loss of||||
|uniform taxes|1.OZ|3.7Z|7.2Z|
|Welfare gain of||||
|unrestricted taxes|0.4Z|1.OZ|2.3Z|

TABLE 2.5

|The Effect of|Aversion|to Inequ|ality with|half pla|n|
|---|---|---|---|---|---|
|Tax Group e=1|e=0.5|e=O|e=-l|e=-2|e=-10|
|Low<br>41Z|322|28Z|24Z|23Z|23Z|
|Medium<br>'1Z|43Z|45Z|47?|47Z|47Z|
|High<br>41Z|72Z|76Z|79Z|81Z|84Z|
|Welfare loss of<br>uniform taxes|1.7Z|3.7Z|7.0?|9.5Z|12.2Z|
|Welfare gain of<br>unrestricted taxes|0.5Z|1.O|1.8?|2.9Z|9.9Z|

Note: The low tax group contains goods 1, 2 and 3 (Agriculture, Forestry and Animals). The high tax group contains goods 6, 7, 9,<sup>10 and 12</sup> (Metallurgy, Electricity, Petroleum, Heavy Chemicals and Heavy Machinery). All other goods are in the medium tax group.

The analysis of the effects of cascading is made more complex in China because of the coexistence of VAT and Product Tax. Since an industry<sup>subject</sup> 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,<sup>the amount</sup> of taxation that has been borne by inputs into an industry subject<sup>to Product</sup> 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<sup>present in</sup> industries subject to VAT: while the tax paid on immediate inputs<sup>is refunded,</sup> this is not the case for taxes paid on inputs into the supplying industry (unless that industry is also subject to VAT). This point is of importance<sup>in</sup>
14 the design of export rebates that typically 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; this is borne out by the calculations reported below.

Column (4) of Table 2.6 shows the cascading effect0l, i.e., the wedge between producer prices under the existing system of taxation and that prevailing under a VAT covering all sectors at the same statutory rates as at present. To this column (5) adds the present wedge between consumer and producer prices [column (3)] to arrive at the full tax burden. The table shows that there are considerable differences between the statutory tax rate and the full tax burden. Thus, some basic intermediates such as electricity, coal and coke and heavy chemicals suffer taxation that is well in excess of their statutory rates; this is also true of the sectors statutorily subject to Business Tax. It also illustrates the point that sectors subject to VAT suffer less from cascading, although they are affected to some extent.

The extent of cascading is, however, understated by Table 2.6. This is because unavailability of data precluded incorporating the effect of taxes paid on capital goods. In contrast to other intermediate inputs, the effect of cascading is not ameliorated in this case even in sectors under the existing VAT, because the VAT does not allow credit for taxes paid on purchases of fixed assets.

The calculations confirm that the existing system of indirect taxation is less efficient than a single stage sales tax or a value added tax. They also lend support to the notion that a VAT covering all sectors would, by eliminating the cascading effect of indirect taxes, make the incidence of taxation more closely approach that desired by policymakers in formulating the statutory rates of taxation. It would also provide a framework that ensures duty free access to all inputs, direct and indirect, going into export production.

# 2.6 Equity

Indirect taxes are not seen as an equity-enhancing instrument in China, except in the sense of equalizing profitability across enterprises. However, the equity impact of existing taxes is complicated by the fact that taxes set with reference to enterprise profitability, when shifted on to prices of free market sales, have different effects on households at different income levels.

> W The way in which this is calculated is explained in World Bank (1990, p. 221).
15 Table 2.6. The Effects of Tax Cascading

|4)<br>|(2)<br>Type<br>|(3)<br>Statutory|(4)<br>Cascading<br>|(5)<br>Full|
|---|---|---|---|---|
|Sector|of Tax|Tax|Effect|Tax|
|Agriculture|Exempt|0|4Z|4Z|
|Forestry<br>|Exempt|0|1%|1%|
|Animal husbandry<br>|Exempt|0|2Z|2%|
|Sideline<br>|Exempt|0|7%|7Z|
|Fishery<br>|Exempt<br>|0<br>|5Z|5%|
|Metallurgy<br>|VAT|142|3Z|17Z|
|Electricity<br>|Product|5Z|5%|lOZ|
|Coal and coke<br>|Product<br>|32|6%|9%|
|Petroleum<br>|Product<br>|30Z<br>|11%|41Z|
|Heavy chemicals<br>|Product|15Z|112|26Z|
|Light chemicals<br>|VAT|20X|4%|24%|
|Heavy machinery<br>|VAT|14%|2%|16%|
|Light machinery<br>|VAT|16Z|3%|19%|
|Construction<br>|||||
|materials|Product|5%|8%|13%|
|Heavy forestry<br>|Product|1OZ|8%|18%|
|Light forestry<br>|VAT|14Z<br>|3%|17%|
|Food<br>|VAT<br>|16Z<br>|2%<br>|18Z|
|Textiles|VAT|18%|2Z|20%|
|Clothing|VAT|14%|2Z|16Z|
|Paper|VAT|14%|2%|16%|
|Other<br>|||||
|manufacturing<br>|VAT|14%|3%|17%|
|Construction<br>|Business<br>|3%|10%|13Z|
|Transport|Business|5%|7%|12%|
|Commerce|Business|3X|6%|9%|

Data that would permit an analysis of 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 expenditures of almost all Chinese households, it is the exemption of most 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 with given consumer prices, their impact appears to fall on producers.
16

# 2.7 Price controls as implicit taxes

In view of the fact that the system of price controls<sup>is an implicit</sup> subsidy to users financed by an implicit tax on<sup>producers, reference was made</sup> above to the need to view taxes and price controls<sup>an integrated system. This</sup> has already been illustrated in terms of the constraining<sup>role of the dual</sup> pricing system in tax reform. This subsection looks<sup>at price reform more</sup> closely. Since indirect taxes are levied principally<sup>on non-agricultural</sup> goods, the discussion on price controls is<sup>confined to non-agricultural goods</sup> as well.

The subsidy to consumers implicit in price controls on<sup>final goods may</sup> be tentatively calculated as follows. These are based<sup>on data published in the</sup> Statistical Yearbook of China 1987 (SYC) and<sup>relate to the year 1986. The SYC</sup> presents data on the ratios of market prices<sup>to state list prices for</sup> 'Miscellaneous goods for daily use' and 'Other'.<sup>The former category is taken</sup> to mean the same as 'Daily articles' in the table on retail<sup>sales while the</sup> latter is taken to include all other categories<sup>of consumer goods apart from</sup> food. The ratio of rural market price to state<sup>list price is less than one for</sup> "Miscellaneous goods for daily use' and this<sup>suggests that the rural goods may</sup> be of inferior quality. For this reason, the urban<sup>market price (for both</sup> categories of goods) is used as the best measure<sup>of the market price. This may</sup> lead to an overestimate of the subsidy implicit in price controls.

The ratio of urban market price to state<sup>list price was 1.08 for</sup> 'Miscellaneous goods for daily use' and 1.30 for<sup>'Other".6' The magnitude of</sup> the subsidy also depends on the proportion<sup>of sales that take place at</sup> controlled prices. It is difficult to obtain<sup>detailed information on this, but</sup> the State Price Bureauz/ says that in 1986,<sup>47 percent of consumer goods</sup> were sold at state list prices, 19 percent at<sup>guidance prices§' and 34</sup> percent at market prices. No figures are available<sup>on the relationship between</sup> guidance prices and state list prices. The present<sup>calculations assume that</sup> they are equal, and this provides another<sup>element of overestimation of subsidy</sup> implicit in controls on non-agricultural final goods.

The above implies that about 70 percent<sup>of 'daily use goods" are sold at</sup> state-list prices. The prices of these goods<sup>are 8 percent below market price.</sup> The average price of daily use goods is therefore<sup>reduced by 70 percent of 8</sup> percent = 5.6 percent. For other goods, 60 percent<sup>of the sales are at a price</sup> that is 30 percent lower so that average prices<sup>are lower by 18 percent. The</sup> table of retail sales indicates that daily<sup>use goods account for approximately</sup> 10 percent of retail sales, while other non-agricultural<sup>goods account for</sup> §/ These ratios have varied considerably over the<sup>last few years, increasing</sup> during the inflationary period of 1988/9 and<sup>decreasing more recently.</sup> 7/ Quoted in World Bank (1990).

8/ Guidance prices are applied to some consumer<sup>prices instead of State list</sup> prices. They are maximum prices, rather than fixed<sup>prices, and are easier to</sup> change than list prices.
17 approximately 36.5 percent of retail sales. The effect of controlling prices of non-agricultural goods on an index of retail prices is therefore approximately 7 percent (0.1 times 5.6 percent plus 0.365 tines 18 percent). This is something of an overestimate of the subsidy implicit in price controls on non-agricultural goods, first, because of the assumptions stated above, and second, because households spend some of their income on items that are not included in retail sales.

This subsidy to consumers is financed by the producing enterprises. It is therefore interesting to consider the effect of removing these controls on revenue and industry profitability. The simplest assumption on the effects of eliminating price controls on non-agricultural final goods is that these 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 implicit in controlled prices, although this in turn could be offset by explicit subsidies to households. The simple assumption is adopted here.

# Revenue effect

With the above assumption, the argument used before may be adapted to show that the average price increase for articles of daily use would be 5.6 percent. Total retail sales for these goods in 1936 was Rmb 43.5 billion. The price increase would therefore yield a potential transfer to enterprises of 0.056 times this figure = Rmb 2.436 billion. The average price increase for other non-agricultural goods would be 18 percent on retail sales of Rmb 154.2 billion and yield a potential transfer to enterprises of Rmb 27.756 billion. The total potential gain in profits from the price increases would therefore be Rmb 30.192 billion. However, with an average VAT rate of 15 percent, an amount equalling Rmb 4.53 billion would accrue as extra VAT revenue, leaving Rmb 25.66 billion or a little under 8 percent of total industrial value added. With an enterprise income tax of 49 percent, the revenue gain from this source would equal Rmb 12.57 billion. The total revenue gain would thus be Rmb 17.1 billion or close to 20 percent of total Product Tax and VAT revenue. Additional after-tax profits would, according to existing guidelines, be distributed among investment and workers' remuneration.

# Profitability effect

In order to look at the sectoral distribution of increased profits, it is necessary to make assumptions about which industries produce each category of goods. The tentative allocation of industries, together with their 1986 value added figures are listed here:
18 Articles for Daily Use Chemicals for Daily Use Rmb 2.689 billion Metal Products for Daily Use Rmb 2.788 billion Machinery for Daily Use Kmb 5.291 billion Electric Equipment for Daily Use Rmb 2.830 billion Furniture Rmb 1.727 billion Total Value Added

# Rmb 15.325 billion

Note: Value added for the first four industries was not directly available and had to be estimated by calculating the ratio of value added to net output for a broader industry definition (for example, chemicals), and using this ratio to convert from net output to value added.

# Other Goods

Coal Rmb 12.898 billion Textiles Rmb 30.875 billion Clothing Rmb 5.642 billion Leather and Fur Rmb 2.817 billion Paper Rmb 5.669 billion Cultural Goods Rmb 1.647 billion Arts and Craft Rmb 2.950 billion Rubber Rmb 5.050 billion Plastics Rmb 4.652 billion Total Value Added Rmb 72.200 billion Looking at the industries producing Articles for Daily Use, the increase in potential profit is Rmb 2.436 billion against a 1986 value added of Rmb 15.325 billion. Therefore the potential gain to those industries from relaxing price controls would be approximately 16 percent of value added. For the industries producing other goods, the potential gain of Rmb 27.756 billion may be compared with a value added of Rmb 72.200 billion to give a ratio of 38 percent. While both sets of numbers would have to be revised downwards by the VAT rate applicable to those industries, as in the aggregative calculations above, were the corresponding classification of rates available, the exercise indicates that the profitability effects of price decontrol will vary greatly across sectors of the economy.

Consider finally the effects of decontrolling intermediate goods prices on industrial profitability. It is assumed (i) that enterprises maximize profits9 and (ii) that the dual pricing system has encouraged marginal enterprise decisions to be made on the basis of uncontrolled market prices. This implies that the increase in intermediate goods prices to free market levels, being analogous to the removal of a lump sum subsidy,will have no 2/Perkins (1988) suggests that enterprise managers pursue increased profits in order to benefit their employees, through the profit retention system
19 effect on prices faced by consumers. The extent of sales between agriculture and non-agriculture suggests that it makes sense to examine the effects of decontrolling all intermediate prices (not just of non-agricultural goods).

The effect of decontrolling intermediate goods prices is the reallocation of profits between supplier enterprises and purchasing enterprises. Unfortunately, hardly any information is available on the extent of the differences between free market prices and state list prices for intermediate goods. Also, up to date information on inter-industry transactions was not available. However, table 2.7 presents illustrative calculations of the effects on industrial profitability (measured as a percentage of gross value added) of raising intermediate good prices, using the 1981 input-output table for China. The precise effects of price increases would depend on the proportions in which each industry bought each of its inputs at State list prices and free market prices. As we have no information on this, it is assumed that, for any one input, each industry has the same ratio of list price to market price purchases.

The first column reports the calculated effects of a 20 percent increase in the average price of all intermediate goods. However, not all intermediate goods are underpriced to the same extent: Dai (1989) regards the underpricing of "higher" level intermediates such as elect.icity and communications as more serious than the underpricing of "middle' level intermediates such as ferrous and non-ferrous metals. It is therefore necessary to look at examples of increasing individual intermediate good prices. The second column reports the calculated effects of a 20 percent increase in the price of electricity. The third column reports the effect of a 16 percent increase in the average price for metallurgy. The fourth column reports the same figures for a 16 percent rise in average coal prices. The fifth column reports the effects of a 10 percent rise in the average price of construction materials.

These changes in sectoral profitability in relation to value added following price reform could in principle be offset by suitable changes in the rates of VAT. However, this will not necessarily lead to a more uniform set of tax rates because price controls are not the only cause of differences in profitability; another major cause is the unequal distribution across enterprises of capital goods historically provided without charge by the State. Free markets with uniform taxes will only equalize profitability if all sources of inequality are removed.

# 3. DIRECT TAXES

# 3.1 The system of enterprise income tax

From the point of view of revenue, the income tax from enterprises is second to the Product Tax, VAT and Business Tax. Direct taxation of business income varies according to the type of enterprise. These include (i) state enterprises, (ii) collective enterprises, (iii) individual household enterprises, (iv) joint ventures, and (v) foreign enterprises.
20 TABLE 2.7 Effects of Intermediate Goods Price Changes on Sectoral Profitability

|Sector|(1)|(2)|(3)|(4)|(5)|
|---|---|---|---|---|---|
|Metallurgy|+20%|-<br>4.1%|+30.6Z|-<br>2.2Z<br>|-0.4Z<br>|
|Electricity|+17%|+25.3%|-<br>0.1Z|-<br>2.82|0|
|Coal and Coke|+13%|-<br>1.52|-<br>1.0Z|+20.1Z|-0.3%|
|Petroleum|+12%|-<br>0.8Z|-<br>0.7Z|0|-0.2Z|
|Heavy Chemicals|+21Z|-<br>4.9Z|-<br>0.4Z|-<br>2.2Z|-0.1Z|
|Light Chemicals|- 52|- 0.5%|-<br>0.42|-<br>0.2Z|-0.1%|
|Heavy Machinery|- **9%**|-<br>1.1%|-<br>6.8Z|-<br>0.3Z|-0.2%|
|Light Machinery|-18%|-<br>0.9%|-10.0%|-<br>0.3Z|-0.2%|
|Construction Mats|+15Z|-<br>3.4%|-<br>1.1%|-<br>2.8Z|+17.2Z|
|Heavy Forestry|+13%|-<br>0.7Z|-<br>0.32|-<br>0.42|-0.12|
|Light Forestry|-11%|-<br>0.8%|-<br>2.1%|- 0.2Z|-0.2Z|
|Food|-37Z|- 0.2X|0|-<br>0.1Z|0|
|Textiles|- 3%|-<br>0.7%|-<br>0.2%|-<br>0.2Z|0|
|Clothing|-40%|- 0.1X|-<br>0.1%|0<br>|0|
|Paper|-<br>3Z|- 1.3Z|- 0.2%|- 0.5Z|-0.1Z|
|OtherManufactures|+1Z|- 3.9X|- 0.3Z|-<br>0.5%|-0.3%|
|Construction|-53%|- 0.7Z|-<br>5.2Z|-<br>0.2Z|-7.0O|
|Transport|+10%|- 0.2%|-<br>0.2Z|-<br>0.4%|0<br>|
|Commerce,etc.|-<br>2X|-<br>0.3%|0|-<br>0.1%|-0.lZ|

# Notes:

Column (1): 20% increase in the<sup>average price of all intermediate goods</sup> Column (2): 20Z increase in the<sup>price of electricity.</sup> Column (3): 16% increase in the<sup>average price for metallurgy.</sup> Column (4): 16% increase in average<sup>coal prices.</sup> Column (5): 10% increase in the<sup>average price of construction materials.</sup>

# State Enterprises

State enterprises are divided into<sup>three categories for tax purposes.</sup> Large- and medium-sized enterprises<sup>pay a flat tax rate of 55 percent on their</sup> taxable profits. Small enterprises<sup>use an eight bracket progressive structure</sup> with rates ranging from 7 to 55<sup>percent. Taxable income equals enterprise</sup> income minus business costs. Depreciation<sup>of fixed assets is an important</sup> deductible cost and is accumulated<sup>in a depreciation fund. The enterprise</sup> income tax further allows deductibility<sup>of principal as well as interest</sup> repa-ments on bank loans, a point<sup>that is taken up in more detail below.</sup> In addition to income taxes, large-<sup>and medium-sized state enterprises</sup> face an income adjustment tax on profits<sup>net of income tax, that varies from</sup> entetprise to enterprise. This<sup>tax</sup> addresses the wide variation in enterprise profits reflecting circumstances other than<sup>enterprise efficiency. Itis used</sup>
21 to equalize profitability within a sector, given that the differential structure of product tax-cum-VAT rates can only achieve such equalization on a cross-sectoral basis. Part of its rationale derives from the need to charge enterprises for variations in profit arising from historically given and unequal endowments of free fixed assets. However, it is difficult to distinguish between differences in profitability arising for this reason as opposed Lo variations in quality of management. The income adjustment tax is based on 1983 profit margins and is seen as temporary.

# Collective Enterprises

An income tax on collective enterprises was introduced in 1985. Collective enterprises are collectively owned rather than state owned and range from large businesses to small partnerships. Taxable income equals collective enterprise income minus business costs and indirect taxes. Depreciation, which must be accumulated in a fund, is broadly similar to that allowed for State enterprise. While interest payments on bank loans are fully deductible, only 60 percent of principal payments enjoy tax-deductibility. Income tax is computed accordingly to an eight bracket progressive schedule that is different from that used for small State enterprise. The income tax burden on collectives is generally lower than that on a State enterprise earning the same profits.

# Individual Household Enterprises

An individual household enterprise income tax was introduced in 1986. As with state and collective enterprises, taxable income equals business income minus costs and indirect taxes. Individual household enterprises face a ten bracket progressive schedule with rates rising from 7 to 60 percent. A surtax of 10 to 40 percent is imposed on taxable income above 50,000 yuan per year.

# Other Enterprises

The taxation of joint ventures and foreign enterprises is complex and lies outside the scope of this paper.' Taxes on state enterprises raise the bulk of the revenue from enterprise income tax, the remainder of this section concentrates on them.

# 3.2 Contract Responsibility System

Income taxation of state enterprises can be substantially altered by the contract responsibility system. This appears to be modelled on the "responsibility system" for agriculture, which set quota outputs that had to be sold to the state at fixed prices, leaving farms free to sell any output over the quota on the free market. It is also based on the old quota responsibility system, otherwise known as the "economic responsibility system", that was tried in some enterprises in 1981/82 as part of the 12See World Bank (1990, pp. 172-174) for a description of the main features of the tax treatment of joint ventures and foreign enterprises.
22 evolution of enterprise reform. That system required the enterprise to deliver a "profit quota" to the government and allowed it to retain a very high proportion of above-quota profits.

It was thought that the low marginal tax rate on above-quota profit would infuse a measure of dynamism and risk-taking into State enterprises. However, since quotas under the "economic responsibility system" were set every year, enterprises in practice made little effort to produce above their designated quota, fearing that superior performance would send the authorities a signal about the true potential of the enterprise and elicit a higher quota in subsequent years (the "ratchet effect"<sup>1</sup> "/). The quota responsibility system led, furthermore, to extensive bargaining both before and after the contract, thereby running counter to the spirit of substituting rules for discretion in relations between the State and State-owned enterprises.

The contract responsibility systems that are currently in use are negotiated between the enterprise director and the supervisory agencies and cover items such as profit delivery, investment, technical innovations and the tying of wages to economic efficiency. They usually cover a period ranging from two to five vears, a feature that is intended to alleviate the consequences of the short-term ratchet effec-. Of the large number of systems in operation, the most common is the Contract Management Responsibility System, (CMRS), which is believed to cover between 60-70 percent of enterprises. This typically selects the existing enterprise director as the contractor and ties employee rewards directly to enterprise performance. In one form of the CMRS (double contracting and single linkage), enterprises must turn over a certain amount of direct plus indirect taxes every year, with shortfalls if any being made up from its own funds. The growth in reinvestment and the wage bill is tied to the growth of profits and taxes Another variant (responsibility for annual increase in profit remittance) grants exemption from indirect taxes but requires that profits equalling a fixed base amount plus an annual percentage increase (usually 7 percent) be handed over to the government. A third variant fixes a constant annual profit delivery for the duration of the contract, with a specified sharing ratio for above-quota profit, whereas a fourth variant differs from the third in allowing the enterprise 100 percent of above-quota profits or lower-than-targeted losses. Finally, the sectoral input-output responsibility systems of the CMRS apply to petroleum, coal, chemicals, iron and steel, nonferrous metals, railways, posts and telecommunications, and civil aviation. Contracts range from 3 to 4 years.

Approximately 9 percent of enterprises fail to meet profit targets under contract. In such cases, the shortfall is supposed to be made up from retained earnings and depreciation funds of enterprises. In practice, enterpri.ses do not take the entire shortfall 'rom these sources. There are two solutions: (1) banks forgive loans to enterprises; and (2) the Finance Department compensates for the loss from its budget. Furthermore, where the enterprise fails to meet its contract because of unfavorable price changes, it can appeal to the Finance Department of its relevant industry ministry on "objective" grounds.

11The ratchet effect has been extensively discussed in the literature on Soviet planning, for example Weitzman (1976).
23

# 3.3 Problems with the current system

Although revenue from the enterprise income tax is second only to indirect taxes, its recent growth appears not to have kept pace<sup>with profits.</sup> The profit tax and adjustment tax together raised Rmb 81.9 billion in 1986<sup>and</sup> Rmb 81.5 billion in 1987. This appears, in part, to be a consequence of the contract responsibility system which uses profit quotas that are either constant or gr3w at a rate less than that of the industrial<sup>sector, together</sup> with a marginal rate of tax that is significantly below the basic rate.

The substitution of profit remittances by profit taxation at a uniform rate and the resulting link between profits and remuneration of staff in enterprises can be seen as an attempt to increase enterprises'<sup>responsibility</sup> for their own profits and to reduce the role of discretion in dealings<sup>between</sup> enterprises and their supervising bureaus in favour of rules. Although it c%used a decline in budgetary receipts vis-a-vis 100 percent taxation,<sup>the</sup> rapid growth of enterprises in Sichuan province where it was experimentally introduced (three to four times that of the average State enterprise) indicated that it had very positive incentive effects.

Although this development served to harden the budget constraint in State enterprises, it is nevertheless true that considerable disc.:etion characterizes the interpretation of tax rules. This manifests itself in deviations in practice from the 55 percent income tax rate, in the application of various extrabudgetary 'clawback" measures to profitable enterprises<sup>and,</sup> correspondingly, in the extension of subsidies and other preferences to finance wage increases and bonus payments in loss-making units.

The role of discretion has been further heightened with the introduction of the contract responsibility system, which appears to provide a vehicle for extending significant tax preferences to enterprises that are able<sup>to bargain</sup> successfully with the authorities. The CMRS allows tax liabilities to be contracted virtually on an enterprise-by-enterprise basis and this strengthens rather than weakens the symbiotic relationship between supervisory agencies and State enterprises. Consider three examples: one enterprise<sup>suffered an 85</sup> percent marginal tax rate on above quota profits, another was<sup>characterized by</sup> a profit quota and a zero marginal tax rate on above quota profits,<sup>and a</sup> third had enjoyed exemption fromr both income and indirect taxes.

The tendency to so tailor tax liabilities is sometimes<sup>defended on the</sup> grounds that variations in contract terms simply reflects<sup>variations in</sup> enterprise circumstances. Endowments of freely provided fixed assets vary across enterprises for historical reasons, as does the<sup>mix between such assets</sup> and more recent acquisitions which are no longer free to State enterprises. Since contracts attempt, inter alia, to encourage efficient use of fixed assets and elicit some payment to their owner, i.e., the<sup>State, it is argued</sup> that they must be tailor made to individual enterprise circumstances.

The introduction of a degree of discretion as high as that<sup>called for by</sup> the above argument, however, has a number of serious disadvantages.<sup>First,</sup> enterprise-specific variations in tax payments inhibit competition and limit
24 incentives to restructure inefficient enterprises. Second, inter-provincial rivalries reflecting lack of coordination among the industrial policies of the provinces add pressures for tax preferences via the contract responsibility system, leading to erosion of tax revenue.

Finally, the inclusion of tax payments in contracts removes an important instrument of macroeconomic management from central government conitrol. The problem is exacerbated by the fact that the alleviation of ratchet effects requires such contracts typically to run for 3 to 4 years, thus lengthening the period over which direct tax instruments becomes 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 State enterprises and the role of the government as macroeconomic manager for the economy as a whole.

Some of these difficulties could be avoided if state enterprises paid both direct and indirect taxes on the same basis as other categories of enterprise, thus fulfilling their obligations to the State as a collector of revenue. The State as owner of the enterprises could then take some share of the after tax profits, and it is here that contracting can have a role in providing incentives and allowing enterprises with different quantities of freely provided assets to make different payments to their provider.

# 3.4 Statutory and Effective Rates ot 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. This effect is summarized in the 'marginal effective tax rate" (METR), estimates of which are presented in Table 3.1.12, These figures are best treated as illustrative. But they serve to indicate the divergences between statutory and effective rates arising from interactions between taxation, inflation and the mode of financing of investment projects. The complexities of the institutional setup governing investment ir. 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.

Column (2) shows the METR on a project financed entirely by retained earnings with an inflation rate of 20 percent. Large State enterprises face the highest METRs because of their high statutory rate and an additional transportation and energy fee. The advantages of debt financing are shown in column (3) for a project financed 50 percent by debt and 50 percent by retained earnings. The sharp decline in METR for all three types of enterprises is due to two reasons. First, the deductibility of I<sup>1</sup> We are indebted to Tony Pellechio for performing these calculations. The methodology is described in Pellechio (1987).
25

# Table 3.1 China: Marginal Effective Tax Rates for Investment in Fixed Assets by Type of Enterprise

(In percent)

||Statutory<br>tax rate|10OZ financing<br>through retained<br> <br>earnings<br>20Z inflation|<br>50 <br>50Z<br>20Z|_Z_debt<br>retai<br>infla|financing;<br>ned earnings<br>tion|
|---|---|---|---|---|---|
|Large state||||||
|enterprises|55|87.3|||48.4|
|Small state<br>and collectiv<br>enterprises|e<br>35|50.3|||30.1|
|Individual||||||
|household||||||
|enterprises|40|57.5|||34.6|

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, and represents a major difference between enterprise income tax in China and international practice.

Two alternative kinds of corporate taxation are considered efficient on economic grounds. The first, or income tax approach, tries to make taxable income approach economic income as closely as possible. A second approach attempts to tax the enterprise on a so-called "cash flow" basis, either by using real cash flow (r base), the difference between sales and purchases of goods and services, or by using real plus financial cash flow (r + f base), the difference between cash receipts (including loan proceeds) and cash expenditures (including principal and interest payments).

Both the comprehensive income tax and the cash flow tax can be shown to preserve efficiency by neither taxing nor subsidizing debt-financed investment at the margin. The income tax reduces both the cost of capital, comprising depreciation and financial costs, and profits by the rate of tax. Under the cash flow tax, the complete writeoff of investment expenditures against enterprise taxation at the time of the investment also reduces the cost of a project to the investor by the rate of tax, while profits from the investment
26 are taxed at the same rate. This symmetric treatment of costs and benefits makes the tax on marginal investments zero.>/ It is therefore seen that the tax-deductibility of principal and interest in China embodies part of the provisiors of the real plus financial cash flow tax ("r + f base") but without including loan proceeds as part of the tax base. While the replacement of budgetary grants with bank loans has been a step consistent with enterprise reform, this generous treatment of amortization and interest on the latter provides very substantial incentives to investment. This is anomalous in general but particularly so at times when ozer-investment by enterprises is considered to be a serious problem.

Most loans in China are amortized over five years. Table 3.2 provides information on gross fixed investment by State-owned units for the years<sup>1982</sup> to 1986, together with the amount of domestic bank loans involved in such investment. It is also known that interest rates on fixed investment lending were increased in 1985 by about 3 percent to somewhat over 10 percent for five year funds. The left-hand side of the last column in the table presents figures on amortization of those loans by State enterprises in 1986, on the assumption that interest rates were 7 percent for loans extended from 1981 through 1984 and 10 percent thereafter. It calculates amortization in 1986 to be Rmb 23.92 billion.

There are instances of enterprises being allowed to repay loans over periods longer than five years. To assess the importance of such a provision, the calculations above were reworked with a loan term of eight years. The amortization figures for this case appear on the right-hand side of the<sup>last</sup> column in Table 3.2. The Statistical Yearbook of China, 1987 reports that profits and taxes from State enterprises equalled Rmb 134.14 billion in that year, of which<sup>Rmb</sup> 65.15 was taxes, leaving Rmb 68.99 billion as after- tax profits.This yields an effective tax rate of 49 percent = (65.15/134.14). Inclusion of amortization on existing loans in the tax base would lead to the situation described in Table 3.3.

W<sup>1</sup> These arguments are spelt out in Atkinson and Stiglitz (1980) and King (1986).
27 Table 3.2 Amortization of Bank Loans by State-Owned Enterprises, 1986 (Rmb billion)

||1981|1982|1983|1984|1985|1986<br>-|
|---|---|---|---|---|---|---|
|Gross Fixed|||||||
|Investment by<br>|||||||
|State-Owned<br>|||||||
|Units a/|101.1|120.0|136.9|183.3|254.3|302.0|
|of which<br>|||||||
|Financing through|||||||
|Domestic Banks|9.1|13.7|13.6|18.3|38.7|45.0|

||5year<br>8<br>Term|Year c/<br>Term|
|---|---|---|
|Amortization of Loans<br>|||
|extended in 1981 b/<br>|-|1.25|
|1982<br>|3.14|<br>1.75|
|1983|2.90|<br>1.62|
|1984|3.64|<br>2.03|
|1985|6.94|<br>3.68|
|1986|7.30|<br>3.87|
|Total Amortization|23.92|<br>14.20|

- a/ Gross fixed investment equals "investment for capital construction' and "investment for equipment renewal and technical transformation".

- b/ It is assumed that the interest rate was 7 percent on loans extended in the first four years and 10 percent for those in the last two years.

- c/ Bank loans are taken to be zero before 1981.
28 Table 3.3 Enterprise Profitability with<sup>and without</sup> Principal Deductibility

|BEFORE CHANGE IN<br>TAX TREATMENT||AFTER CHANGE IN<br>TAXTREATMENT|
|---|---|---|
||(Rmb billion)||
||5 Year Term b/|8 Year Term c/|
|Taxable profit134.14|134.14+23.92=158.06|134.14+14.20=148.34<br>|
|Taxes<br>-<br>65.16<br>After tax|Taxes a/<br>=-76.77|Taxes a/=-72.08<br>|
|profit<br>=68.99|=<br>81.29<br>LESS|=<br>76.26|
||Amortization-23.92|-14.20|
|Retentions<br>=68.99|=<br>57.37|=<br>62.06|
|Revenue increase|18Z|11z|
|Percentage decline<br>in retentions|17Z|10o|

a/ Using a rate of 49 percent.

b/ Calculated amortization in 1986 with 5 year<sup>term=Rmb23.92</sup> billion c/ Calculated amortization in 1986 with 8 year<sup>term=Rmb14.20</sup> billion Thus a change in tax treatment of existing loans<sup>would have led for 5</sup> and 8 year term loans respectively to increases<sup>of18percent and 11 percent</sup> in income tax revenue from State enterprises.<sup>There would have been</sup> respectively a 17 percent and 10 percent<sup>decline in retentions of State</sup> enterprises and, hence, a corresponding<sup>decline in any measure of their</sup> profitability, whether defined vis-a-vis the<sup>value of fixed assets or relative</sup> to sales.

This calculation embodies a number of biases.<sup>First, the cost of credit</sup> is effective in controlling investment only<sup>if disallowance of amortization</sup> leads to a reduction in borrowing, so that the<sup>fixed base assumption used here</sup> in the absence of other information overestimates<sup>both the revenue gain and</sup> the resulting decline in enterprise profitability.<sup>This is partially offset by</sup> the fact that the figures do not take into account<sup>the situation in</sup> collectives, where the share of bank loans<sup>is significantly higher than that</sup> for State enterprises. Second, inasmuch<sup>as the figures for tax collections</sup> include the adjustment tax, the average<sup>rate of income tax would have been</sup>
29 somewhat lower than 49 percent. This leads to an upward bias in the<sup>estimates</sup> for revenue gains but also overstates the decline in retentions.

There is, however, an important offsetting influence. The calculations refer to 1986, the latest year for which data were available.<sup>Inasmuch as</sup> borrowing from the banking system has been higher in 1987 and<sup>1988 compared to</sup> previous years, the calculations probably underestimate the proportionate<sup>gain</sup> in revenue and decline in retentiun-z by State enterprises that would occur were the calculations to be done fo, those later years.

In summary, these calculations show that the disallowance of amortization payments as an expense against the enterprise income<sup>tax is</sup> likely to result in significant change in income tax revenue and<sup>enterprise</sup> profitability. Also, the removal of tax-deductibility of amortization<sup>would</sup> make it easier to introduce a VAT of the consumption type without<sup>stimulating</sup> excessive investment in enterprises.

# 3.5 Resource Tax

The controlled price system and state provision of assets are<sup>not the</sup> only factors that could potentially give rise to inter-enterprise inequality. Some inequality is caused by unequal access to natural resources, particularly in the production of coal, oil, gas and minerals. This was partly alleviated by introducing the Resource Tax in 1984 which, while it can in principle be applied to all of these products, applies in practice only to the<sup>first three.</sup> The tax rules require the Resource Tax to be levied on profit (relative<sup>to</sup> enterprise sales) as follows. Enterprise with profit rates up to 12 percent are exempt; those earnings between 12 to 20 percent of sales are<sup>taxed at 50</sup> percent; those between 20 to 25 percent at 60 percent; while profits in excess of 25 percent of gross sales are taxed at 70 percent. However, frequent changes in profitability cause the tax to be levied in practice<sup>at</sup> enterprise-specific rates related to the amount of extraction<sup>of the resource</sup> and its quality.

The fact that it is levied on profit relativ( to sales means that the use of some exhaustible resources (e.g., coal, oil and gas)<sup>are indeed</sup> discouraged by it. However, the rates of taxation are not calculated to reflect such exhaustibility. Also, it is levied in a way that<sup>reduces the</sup> efficiency with which those resources are extracted. Efficiency in nationwide resource extraction requires that, for each resource, the marginal<sup>cost of</sup> extraction (including transport costs) be equal for all enterprises<sup>engaged in</sup> extraction. This condition would be satisfied if producers<sup>were</sup> profit-maximizing and faced the same producer price for output. However, since, the Resource Tax is enterprise-specific, being levied<sup>at a higher rate</sup> on more profitable enterprises, it can offer more efficient producers<sup>a lower</sup> producer price. The tax system can, therefore perversely encourage less profitable producers to expand activity even if their marginal<sup>cost is higher</sup> than that of more profitable enterprises.

Finally, the effectiveness of taxes/charges on resource use<sup>is reduced</sup> in the presence of price controls. In a market economy, a<sup>tax on resource use</sup> will discourage production, raise the market price and therefore discourage
30 consumption of the resource. In contrast, when the price to consumers is fixed, consumption is not discouraged. Instead, due to backward shifting of taxes, production 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 profitability might reduce supply. With fixed consumer prices this would create excess demand and some form of (possibly informal) rationing. This would conserve the resource to some extent without ensuring that it was allocated efficiently, i.e., to those who could make the best use of it.

Efficiency in resource allocation ideally requires that enterprises be charged a price that reflects the social value per unit of resources extracted by them and that risks of exploration and development, where significant, be efficiently shared between the State and enterprises engaged in resource extraction. This is to be seen nct as a tax but as a cost per unit of resource use. The payment would represent a return to the State as resource owner. The cost, being a payment to a factor of production, would normally be deductible against the enterprise income tax.

Such a value is however difficult to arrive at, given the lack of information that attends the volume and quality of natural resource deposits prior to exploration. Different countries have resorted to different arrangements in order to get a return on resources. Many, such as Bolivia, (bismuth, silver, uranium), Botswana, Chile (copper, uranium), Cclombia (uranium, emeralds, platinum), Gabon (uranium), Jamaica (bauxite), Malaysia (iron ore), and Mexico (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) and Indonesia levy excess profits tax, with the latter country charging ad valorem royalty as well. Another mechanism, that is used mainly in the U.S., is the auctioning of resource rights in return for a single payment.

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. Pending the availability of such information, it may be necessary to continue with an excess profits tax or royalty set at a "presumptive" rate based on the experiences of other countries.

# 4. CONCLUSIONS

This paper has described and analyzed the economic consequences of the tax system in China, a country that has been moving gradually towards a market economy for over ten years. In this section we ask what lessons may be derived from that experience for the newly emerging market economies.

The analysis of indirect taxation clearly brought out the importance of viewing tax reform in the context of reform of the economic system as a whole. In particular, the continued existence of price controls has a powerful effect on the profitability of different industrial sectors and makes it difficult to **fully** simplify the rate structure of indirect taxes, a move that would reduce **the** distortion of free market prices. Illustrative calculations however
31 suggested that even in the absence of price reform,<sup>a considerable</sup> simplification of the rate structure, moving perhaps<sup>to two or three different</sup> rates, would be desirable, easing the burden<sup>of administration and reducing</sup> incentives for unproductive rent-seeking.<sup>These results suggest that those</sup> countries which have not liberalized their prices<sup>must make substantial</sup> progress in that directicn if they<sup>are to move towards a single-rate value</sup> added tax in line with best international practice. Such price liberalization can be expected to redistribute income<sup>among State enterprises, a feature that</sup> might call for offsetting measures.<sup>The arguments of this paper--and the</sup> methods developed here to explore their<sup>quantitative implications--may</sup> therefore be applied to a wide range<sup>of economies, whether centrally planned</sup> or not, that are reforming interlinked<sup>systems of administered prices, taxes</sup> and public sector enterprise behavior.

The calculations of the cascading effects of turnover<sup>taxation</sup> demonstrated that the move towards a value added<sup>Lax would indeed improve the</sup> transparency of indirect taxes, allowing tax policy<sup>to be designed more</sup> effectively. This finding reinforces the<sup>arguments for value added taxes that</sup> have already been advanced in Central and Eastern<sup>Europe.</sup> k<sup>4</sup> ' The system of direct taxation in China has had<sup>three goals: the creation</sup> of incentives for enterprises, the collection<sup>of revenue and the equalization</sup> of after tax profits. The first two goals<sup>are common to all tax systems, but</sup> the third arises because of the inequalities generated by the free provision of fixed assets to state enterprises in earlier<sup>years. Attempts to achieve the</sup> third goal have however led to a system where virtually<sup>every large enterprise</sup> negotiates its own tax schedule with the government.<sup>This has subverted the</sup> main aim of enterprise reform, viz., to sever<sup>the close links between</sup> enterprises and the State, with a view to encouraging<sup>competitive forces.</sup> Most emerging market economies share the aim of enterprise<sup>reform, and</sup> so would be well advised to avoid the Chinese<sup>approach to enterprise income</sup> taxation. One obvious solution is the<sup>use of privatization to distance</sup> enterprises from the State and weaken the temptation<sup>to grant special tax</sup> exemptions. However, privatization is a time-consuming process, especially if the aim is to preserve government finances<sup>by obtaining a fair price for the</sup> assets that are sold. It is therefore worth<sup>asking whether state owned</sup> enterprises can, in the meantime, be given<sup>uniform tax treatment without the</sup> government losing all the value of the freely<sup>provided assets, and thereby</sup> possibly having to rely on other distortionary<sup>instruments to preserve its</sup> revenue base. It is here that the Chinese experience<sup>of tax contracting might</sup> be useful, provided it is modified<sup>to apply to after-tax profits. If the</sup> government contracts with each enterprise<sup>for the delivery ofafixed amount</sup> of after-tax profits and allows the enterprise<sup>to keep most or all of what is</sup> left, it will (i) earn tax revenue,<sup>(ii) receive a return on its assets while</sup> helping develop procedures for valuing them, a<sup>useful intermediate step</sup> towards privatization, and (iii) provide<sup>incentives for enterprises to improve</sup> efficiency and meet market demand.

IW See Owens (1991).
32 Finally, the calculations of marginal effective tax rates under alternative assumptions and the discussion of principal deductibility show how easy it is for the tax system to distort the incentives for investment in ways that may not have been foreseen. Policy makers in the newly emerging market economies therefore need to guard firmly against allowing tax concessions for enterprises.