SME Taxation in China Professor Yang Yao China Center for Economic Research Peking University Creating A Conducive Legal & Regulatory Framework for Small and Medium Enterprise Development in Russia A Policy Dialogue Workshop, St. Petersburg, Russia September 14-16, 2003

2 1. China’s Fiscal System Value-added tax is shared between central and local Central: 75%; Local: 25% Corporate income tax Existing firms before 2001: collected by jurisdiction New firms shared between central and local equally Central government monopolizes the special consumption tax All tax rates are set by the central government and uniform across provinces

3 1. China’s Fiscal System Yingyi Qian: Market-preserving Federalism Federalism without the side effects of excessive exaction, regional protection and excessive competition High incentive for local governments to expand their tax bases through economic growth

4 1. China’s Fiscal System Andrei Shleifer: Central control is important Federalism is highly likely to create excessive exaction at the local level, especially when the local economy is not good enough Chinese federalism works because the central government is very strong in the sense that it promotes local leaders largely based on the performance of the local economy Russian federalism does not work because there is not a strong central government

5 1. China’s Fiscal System Its mandate is a State Council directive rather than a law Giving too much discretion power to the central There is a conflict between federalism and vertical administrative control Revenues flow to higher-level governments Responsibility snowballs down to lower-level governments Governments become commercialized, acting more like a corporation rather than a public institution

6 2.SME Taxation SMEs pay less taxes than large firms They are more likely to evade taxes Local governments do not spend much efforts in collecting taxes from small firms Taxes in Yibin city: Wu-liang-ye, a liquor giant with annual sales revenue of more than 15 billion yuan, accounted for half of the city ’ s 2002 tax revenue of 2.9 billion yuan. Seventy to eighty percent of the city ’ s tax revenue comes from firms whose annual tax payment is over 1 million yuan. The local tax system favors smaller firms

7 3. Problems with Taxation High tax rates Value-added tax: 17% Corporate income tax: 33% Personal income tax: taxable income starts very low and the rate is strongly progressive

8 3. Problems with Taxation Ill-defined tax bases The VAT is production-based rather than consumption-based, discouraging investment and technological innovation The deduction for corporate income tax is very restrictive. For example, it does not allow deduction of R&D expenditures and sets a very low limit on deductible wage bills

9 3. Problems with Taxation Too much discretionary power vested in tax officers Negotiation of taxes is common Tax burdens are unequal Corruption is inevitable

10 4. Government Concessions FDI enjoys three-year exemption and five-year reduction of income tax Exports get rebates on VAT High-tech products also enjoy certain tax cuts Employing laid-off workers qualifies tax cuts

11 5. Solutions Increase check and balance at every level of the government Lower the tax rates The effective rate of corporate income tax is already 28% Make taxation more production-friendly Make VAT consumption-based Allow R&D expenditures deducted from corporate income tax Level the competition field between foreign and domestic firms

12 6. Lessons for Russia Judge local officials by growth rates, not by taxes sent to the central government Give SMEs a space Tax exemptions for initial years of operation Tax incentives to obtain specific government goals such as employment Less strict enforcement of the tax code