1. Taxes and Development: India vs. China Roger Gordon UCSD

2. Taxes and Economic Growth: India vs. China What is the role of tax structure in economic growth in India? Evolution of tax structures remarkably similar to that in China Surprising given very different political systems Objective of presentation –Lay out similar development of tax structures during the reforms in the two countries –Suggest a story to explain the observed interplay between taxes and economic reforms

3. Pre-reform Economies Very Similar Initial per capita GDP: –China $175 in 1979 –India $215 in 1991 Dominant role for SOE’s in both countries, with a particular focus on heavy industry Allocation decisions subject to direct government controls Minimal international trade or FDI Tax system had little allocative role

4. Initial Reforms Relax government licensing restrictions and other direct controls Relax controls over allocation of credit Cut tariff rates and nontariff barriers Relax controls over exchange rate and FDI Outcome after 14 years of reform: –China: GDP pc grew from $175 to $536 –India: GDP pc grew from $215 to $548

5. National taxes at beginning of reforms CHINAINDIA Corporate Tax 55% rate50% to 55% rate Excise Taxes High and variable rates

6. High Tax Rates on a Narrow Base Revenue only from SOE’s in China Mainly from large industrial firms in India –Excise taxes confined to manufacturing –Yet manufacturing only 16% of GDP (1991) –67% of corporate tax from manufacturing –40% of revenue from SOE’s

7. Policies Used to Protect Narrow Tax Base Protect heavy industry with tariffs. In India, average effective rate was 75% in 1990 (though reforms cut it to 15% at present) Provide cheap credit to highly-taxed firms Restrict hiring and firing of workers in SOE’s Direct controls on entry and investment in other sectors – “license, permit, quota Raj” Highly taxed industries plausibly larger, rather than smaller on net, due to tax distortions

8. Reforms Relax Controls When relax controls, resources (and accounting profits) shift to low-taxed sectors Major drop in the role of SOE’s, from 68% of paid-in capital in 1992 to 28% in 2002 Drop in size of heavy industry, e.g. capital good production falls from 25% to 7% of GDP Expansion in size of (lightly taxed) service sector Given large tax distortions, reallocation not necessarily an efficiency gain

9. Resulting Fall in Tax Revenue In China, –corporate tax revenue fell from 7.8% of GDP in 1985 to 1.5% in 1993 –Total nontariff revenue fell from 20.5% to 11.5% In India, –excise tax revenue fell from roughly 8.4% of GDP in 1991 to 7.7% by 2004 –But corporate revenue increased from 0.9% to 2.3% –nontariff revenue up from 12.0% to 13.4% of GDP Likely reason for difference is improved tax enforcement in India

10. Further Economic Reform Requires Tax Reform With relaxed controls, narrow tax base creates major distortions Either limit relaxation of controls to preserve some tax revenue and to limit misallocations, or undertake major tax reform China did try a retrenchment in 1988-91, but political and economic costs too high

11. Both Countries Undertook a Major Tax Reform After 15 years of reform, both countries largely replaced excise taxes with a VAT –17% rate in China –16% rate in India Both countries broadened the tax base for indirect taxes –China imposed national taxes on non-SOE’s –India expanding excise tax base to include services and wholesale sector

12. Both countries cut the corporate tax rate to 33% Growing importance of personal income tax in both countries, capturing some income from informal sector But while easy to cut rate on heavy industry, hard to increase effective tax rate elsewhere Revenue in China fell further, from 12.3% in 1993 to 10.1% in 1996 With improvements in enforcement, though, revenue later grew to 17.7% in 2004

13. Tax Structure Now More Compatible with a Market Economy Firms now face closer to neutral tax incentives in allocation decisions With revenue largely unaffected by allocation, government finally has a fiscal incentive to fully support pro-market policies In China, reforms followed by rapid and consistent economic growth In India, a concern that national revenue still comes largely from manufacturing, plus some from service sector

14. Taxation by State and Local Governments If only firms mobile, incentives neutral if collect same taxes per resident, regardless of which firms enter Effective tax rates varied dramatically by type of firm –In China, tax on profits and sales of local firms –In India, excise taxes at variable rates on local firms –Agriculture and service sector very lightly taxed

15. Tax Competition Incentive to protect heavily taxed firms from competition from other locations In China, local governments encouraged entry in heavily taxed industries by providing valuable inputs and cheap credit In India, tax competition undermines revenue collection

16. Implications of Low Tax Revenue Poor quality of public utilities immediately threatens further growth Poor quality education and health care undermines longer run growth –Average education is only two years –Only 35% of age group enrolled in secondary school –One third of children have low birth weight

17. What to Do? Hope tax revenue improves –China’s revenue has indeed improved gradually, growing from a low of 10.1% of GDP to 17.7% now –But the economic costs of waiting can be very high Borrow against future tax revenue. But current deficits already 10.3% of GDP Increased use of user fees, perhaps with private provision? –Key response in China, particularly for roads, education, health, telecom –Problem that poor may do without. Use available budget to subsidize purchase by the poor?

18. Is problem low revenue or poor incentives to provide services? Funding for state governments not THAT low –State revenue plus transfers in India in 2002 was 9.7% of GDP –S&L current expenditures in U.S. were 12.9% of GDP –But current figure for China is 13% of GDP, yet problems remain severe there Incentives to provide services seem poor –Voice: Key difference from China. But provides weak oversight –Exit: But mobility across States low due to language and cultural differences

19. How can Incentives be Improved? Note that incentives high if have user fees Shift funding (and expenditure responsibility) to panchayats, where mobility pressures are greater Tie intergovernmental transfers to population (or # of school kids), providing an incentive to compete to attract residents Break down barriers to mobility –Ease restrictions on rental markets –Ease taxes and restrictions on land sales

20. Why is Deficit so High in India? Some debt appropriate if tax revenue will increase in future National deficit: Response to rapid turnover of party in power? China vs. India or U.S. State and local deficits: Soft budget constraint? –Parallel problems in China –No cases of fiscal bankruptcies –Intergovernmental grants cover any shortfalls, creating incentives to have high debt or poor infrastructure

21. What is to be Done? Shift to fiscal transfers based more on formulas, e.g. population Restrict use of debt by S&L governments to capital projects, perhaps with repayment limited to resulting revenues, a third reason to have user fees Set up clearer legal rules to handle defaults on debts of state and local governments

22. Broader Story about Reform Process Pre-reform, controls essential to protect narrow tax base Reforms relax controls, improving incentives for firms, but undermining tax revenue Pressures force move towards a more neutral tax structure Incentives on firms and government improve, but revenue likely falls further in short-term Can reform policies survive the resulting fiscal pressures? –Risk that poor infrastructure undermines growth –Risk of default on debt –Risk of a populist government undoing reforms