Redesigning the Dragon Financial Reform in the Peoples Republic of China

Prior to economic reforms, Chinas tax structure was based on the Soviet model. Enterprises remitted their profit to the government,

Redesigning the Dragon Financial Reform in the Peoples Republic of China



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line with each levels set of responsibilities. The central governments control over the tax system and share of total revenues will likely have to be increased. The next two sections will address these proposed changes.


The Pre-Reform Tax System

Prior to economic reforms, Chinas tax structure was based on the Soviet model. Enterprises remitted their profit to the government, retaining only what was necessary to pay expenses. Revenues were collected by local governments, and a certain amount was filtered up to the central government. In 1984, this was replaced by a system of enterprise income taxation reform, in which companies were taxed on their profits, as the government tried to respond to economic imbalances created by the emerging private sector. The turnover tax (the Consolidated Industrial and Commercial Tax, or CICT), which had been the largest contributor to the governments annual revenue, was replaced with a business tax, a product tax, and a value-added tax (VAT). These featured highly differentiated tax rates across sectors, types of good and service, and form of firm ownership. Most private firms paid a base tax rate of 33%, while most state-owned enterprises (SOEs) were nominally taxed at 55%. In practice, however, taxes paid were governed by a contract responsibility system (CRS), in which enterprises negotiated individually with local government units. This system created conflict of interest because often the local government was both tax collector and enterprise owner. Not only were there differentiated rates which distort economic activity, there was little incentive for full tax remittance back to the central government under this system. (See Table 6 in Appendix, page 23, for a description of the tax structure from 1985-1991.)

1994 Reforms

In 1994, the Chinese government began to respond to these problems by enacting a series of reforms. The CICT was abolished and the following taxes were created or modified:

Enterprise Income Tax. This unified corporation tax taxes companies at a single 33% rate. Foreign enterprises and joint ventures are still enjoying lighter tax burdens, because of the fierce competition between regions to attract foreign investment, but these privileges are to be gradually eliminated.

Personal Income Tax. Operates on a sliding scale, with a maximum of 45%. Not yet comprehensively-implemented.

Value-Added Tax (VAT). Replaces the product tax of the CICT. Most goods taxed at 17%, but agricultural and food products will be taxed at 13%, and small-scale businesses will pay flat rate of 6%.

Consumption (Excise). Focuses narrowly on “luxury goods:” tobacco, alcohol, gasoline, and a few others.

Business tax for services. Service industries will face a business tax of 3% to 20% on sales in place of the VAT. This tax also will apply to transfer of intangible assets and the sale of real estate.

Capital Gains. A capital gains tax was to be introduced in 1994, but its implementation was postponed because of concern over its adverse impact on Chinas fledgling stock markets.


1996 Reforms

In 1996, China announced plans to reduce its import tariff rate from 35.9% to 23%, while abolishing preferences for certain goods and, importantly, eliminating exemptions from import tariffs (currently, over 80% of imports are exempt from import duties for various reasons). This step alone should help to reduce the recent losses in customs revenue. The Ninth Five-Year Plan also includes provisions to introduce taxes on interest earnings and inheritances, policies designed to reduce income disparity.


Revision of Tax Collection Structure

In order to make the above tax policy changes effective, the tax collection system must be revamped and greatly improved. The current structure is based on a system of revenue contracts between enterprise and government unit, and between local and central governments. One of the necessary reforms involves tax exemptions, which local governments often have the authority to grant to enterprises who for one reason or another are unable to pay their taxes. This is a fundamental weakness in the Chinese fiscal system: local government has decision-making authority to grant exemptions on a tax the proceeds of which may in large part be assigned to governments above. Numerous conflicts of interest can appear to reduce incentives to enforce the tax at the local level.

To address these changes, China in 1994 initiated the setting up of a centrally-managed National Tax Service. This would replace the contract system with a national “tax system,” based on uniform rules of tax assignment and tax sharing. Certain assignments will be assigned to local governments, and others to central government; others will be shared according to predetermined formulas. Interestingly, in 1995, a special police unit was set up to protect tax collectors under this new program.

A potential obstacle to tax reform comes from local governments. Local governments have traditionally supported reforms. But this is because the reforms have usually given them greater autonomy. The tax system reforms need to restore some control over investment and spending back to the central government, which could encounter local opposition. Allowing local governments some discretion over local tax rates can give them some of the autonomy they desire, and provide greater incentive for intergovernmental cooperation.

Few reports exist at present on the implementation of these reforms. Certainly, the spirit and scope of the reforms has been well-received by analysts, though more changes are advocated. But it will take several more years to determine the success of the reform of tax collection structures at the local level.


Intergovernmental Fiscal Relationships

A product of economic reforms in transitional economies is often a shift in intergovernmental fiscal relationships. In the transition from centralized economy to market economy it is often from a relationship where the local or provincial government is the receiver of the “plan” to the local or provincial government proceeds with a greater autonomy. The evolution of this relationship in the PRC has been very similar. However, the provincial or local governments were at an advantage over many other transitional economies because the Chinese system had the following characteristics 1)local implementation capacity was already established in the rural areas 2)China in most areas has a high ethnic homogeneity and 3) there was much to gain by inter-province trading

The very nature of Chinese economic reforms, gradual and incremental, allowed “scaffolding” of behavior. Partial reforms provided the environment to learn behaviors that could then be applied to the next level of reform. Chinese economic reform was also structured on the idea of decentralization. The establishment of Special Economic Zones (SEZs) encouraged the local areas to develop their own strategies to attract business and allowed them the freedom to implement the strategies. The very earliest reforms, breaking up of farm communes, were also carried out at the local level.

Many of the SEZs are doing very well and people living in these areas are enjoying a higher standard of living than they had previously enjoyed. However, tax collection still remains a difficult endeavor with compliance at only 70%. In order to improve the poorest areas in China, policies and programs that are able to move this revenue to the poorer areas will be needed. This can take the form of a better accounting system to ensure that all taxes due the central government for infrastructure development actually arrive there.


Banking Reforms, State Owned Enterprises and the Social Safety Net

In order to put current economic reforms in perspective, understand the recommendations made by the international economic community, and fully address the quagmire of State Owned Enterprises (SOEs), a more in depth look at the interconnectedness of the SOEs and the banking system must be taken. We will attempt to do just that using the context of bank development in the PRC, monetary policy, and ongoing reforms to SOEs.

Reform of the banking system in the PRC has taken on similar characteristics to reform in other areas: i.e., gradual and experimental. At the beginning of reforms the financial sector in the PRC could hardly be called a financial sector. Financial sector development and implementation is a complex undertaking which should include the development of institutions, instruments and markets. Currently in the PRC, banking reform lags behind other areas of reform. This is due to a complex array of policy decisions. No discussion of banking reform in the PRC would be complete without an examination of the current state of SOEs restructuring. Many macroeconomic initiatives are being put on hold in order to bolster a failing state sector and postpone the social upheavals that may be associated with the needed reforms of this sector.


The Central Bank was established in 1984. In 1987 two additional universal banks were formed and non-bank financial institutions were started. In 1988 new capital markets were formed and the secondary trade of government bonds was allowed. In 1990 the Shanghai and Shenzhen stock exchanges were opened. In 1992 all treasury bonds were issued through underwriters. At the end of 1994, the PRC had a total of 13 banks (of which 3 were specialized banks and 3 were comprehensive banks). The new “financial system” contained 20 insurance companies, 391 trust and investment companies and grea

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