Magazine: Foreign Affairs

Issue: November/December 2000 (Volume 79, Number 6)

Title: The Middle Kingdom Runs Dry

Tax Evasion in China

Author: William Gamble

China watchers regularly warn that a raft of well‑known problems besets the Middle Kingdom. These usual suspects include a ballooning population, environmental degradation, growing ethnic tensions, and uncomfortable relations with China's neighbors. But the country has an even more immediate problem that has until now received far too little attention: Beijing can barely collect its taxes. At a time when China's economic growth rate is slowing and its thirst for public funds is growing, this chronic inability to collect taxes has all but crippled the government. And so far, all efforts to address the problem have failed.

Throughout the 1990s, successive crackdowns on tax evaders were launched to little avail. Government income as a share of gross domestic product (GDP) continued to decline throughout the decade, sinking to 12 percent in 1998 from 32 percent in 1978 ‑‑ a rate lower than those of the world's most laissez‑faire economic regimes. At the same time, individual income as a proportion of GDP increased from 49 to 61 percent.

Understanding China's desperate thirst for cash is not difficult. It owes in large part to the enormous losses regularly suffered by the noncompetitive state‑owned enterprises (SOES) that employ most of the workers in urban China. These hemorrhaging businesses must be bailed out by loans from state banks that then become insolvent themselves, requiring recapitalization and extending the economic crisis down the line. Workers laid off by those SOES not kept on life support by the banks also require government support. At the same time, Beijing is spending huge amounts on economic stimulus packages to prop up its GDP. The government also keeps expanding defense budgets to compensate the armed forces for the recent loss of their commercial businesses, which Beijing stripped from them in an attempt to reduce the military's power.

Yet while expenses are increasing, China's government income has dwindled. Beijing has tried to reverse this dangerous trend by improving the efficiency of its tax system; the latest efforts to alleviate the funding drought have included public executions of tax evaders, upgraded computer systems for the tax bureaucracy, intensified scrutiny of bank transactions, and closure of many loopholes. These measures may increase revenues somewhat, but because of the inefficiencies inherent in a centrally planned economy, they will not stop the decline of government revenues relative to GDP.

Part of the problem lies with the modern structure of China's government. In the early stages of China's communist development, economic, political, and legal power was concentrated in the government's hands, and this seemed to work ‑‑ at least at first. But the overwhelming power of the central government devolved over time to local officials and, especially, to managers of large enterprises. These managers also assumed the duties of landlord, mayor, fire chief, and even school principal.

These same local managers and government officials now collude for their own personal interests, those of their enterprise or industry, and those of their locality ‑‑ but not those of Beijing. The result is that Beijing gets an ever‑decreasing share of the tax pie, forcing it to rely on other sources for revenue, such as the few state‑owned firms that do earn profits ‑‑ namely, monopolies in industries such as telecommunications. Years of tinkering have left a tax system full of incentive schemes and loopholes that benefit powerful vested interests but offer no new means to collect taxes from local authorities who protect tax‑evading firms. Devolution of power from the center has, on the one hand, stimulated regional economic growth and reform. But as local governments have attained de facto control, they have seriously weakened Beijing's ability to achieve and sustain macroeconomic stability.

Moreover, the system now depends on the very corruption that makes tax collection so difficult. China's inefficient centrally planned goods‑distribution system requires collusion between managers of state enterprises and lower officials to resolve surpluses and shortages. This has led to the formation of large networks of informal contracts, swaps, reciprocal relationships, and black markets, all of which enrich the participating individuals but add little to government coffers. Despite their negative side effects, however, many of these arrangements are essential for correcting the shortcomings in the state economic system and for maintaining the output of China's state enterprises.

China's managers and government officials, unchecked by legal restrictions, political restraints, or market discipline, have thus become indispensable to the economy. But they enjoy both the incentives and the means to corral large amounts of public resources and have not hesitated to take advantage of such opportunities. Local officials, for their parts, offer tax concessions to managers while finding ways to avoid sharing taxes with the central government. This may help local economies, but it only worsens the tax drought in Beijing.

ENERGETIC AVOIDANCE

A glance at the sorry specifics of China's tax system helps explain just why government revenues are so low. The problems are staggering. To begin with, 70 to 80 percent of Chinese citizens have had no dealings with tax officials in their entire lives. For more than 30 years, in fact ‑‑ from 1948 to 1987 ‑‑ China had no income tax at all.

Today, although most urban wage earners have taxes automatically deducted from their monthly pay packets, a survey of taxpayers in six cities showed that more than 60 percent of them do not even know what the tax threshold is (that is, the amount of income they have to earn before they are required to pay taxes). And if they did understand the system, few Chinese would be happy with it. Expenses are not deductible, and tax rates are not adjusted to account for inflation and the loss of subsidized social services formerly provided to employees by local SOES. The withholding process is unpopular, and various means ‑‑ including payment by cash and bartering ‑‑ are widely used to avoid it. In fact, around 10 million of China's 27 million self‑employed businesspeople have not even registered to pay taxes in the first place. Mounting antagonism against the withholding system has erupted in attacks on tax collectors and tax bureaus and in hostile newspaper stories and editorials. Beijing is finding that merely passing a law does not ensure compliance, especially if the people do not see their interests served.

Oversight is also a problem. Tax officials have enormous incentives to accept bribes to help individuals or enterprises avoid paying taxes. These officials are part of the same government that is trying to stop corruption. But there is no independent agency on the local level to supervise their work or act as a check on venal activities. Quite the reverse: local governments have incentives to ensure that their main sources of revenue ‑‑ local enterprises ‑‑ remain competitive by avoiding any extra costs, including taxes. Since evasion has been institutionalized, complying with the tax code has become more expensive than avoiding it. A citizen who chooses to defy a tax official's extortion and to simply pay according to the official tax code runs the risk of attracting groundless criticism and being fined, and has little recourse for appeal.

SEDUCTIVE SIMPLICITY

In the United States, taxes are organized and codified through a top‑down process, starting with statutes, then regulations and rulings, and then administrative and court hearings. Applying American tax law is an almost continuous process, one concerned with accurately and fairly ascertaining specific facts and then correctly interpreting and applying the law to them. The process is enmeshed with myriad other laws that define, refine, and elucidate the system. Together, these laws provide a uniform and fairly transparent process for both taxpayers and tax collectors.

In contrast, China's new tax statutes and regulations are both skimpy and inflexible. They favor accountancy precision over legal finesse and mathematical symbols over words. Their legal simplicity makes no distinctions between the subtleties of individual economic situations and fails to account for the myriad transactions of a sophisticated market economy. There is no adequate system to fairly determine the facts; local officials simply use their (often arbitrary) discretion. A one‑size‑fits‑all system, China's tax code virtually guarantees that its application will be exceptionally unfair, unpopular, and unworkable.

In China the government, local or central, holds the power to tax whatever it wants to whenever it wants to. In defining the categories subject to individual taxation, the Chinese system includes a catchall "other income" category, the meaning of which remains open to interpretation by the finance departments of the State Council (China's cabinet). Exemptions are likewise approved by this same body. Furthermore, the system includes only a standard deduction and provides no adjustments for individual situations. Without specific deductions, both sides of a business transaction are often subjected to tax. Unsurprisingly, a system with this level of uncertainty lacks credibility. And the conditions are ripe for corruption. Without consistency or an honest method of fact‑finding, it becomes safer and more reliable to bribe local tax officials than to submit to the system.

Income tax in China provides less than two percent of government tax revenue, as opposed to the one‑third share it contributes in major developed economies. To make up the shortfall, Beijing relies instead on a regressive value‑added tax (VAT) to produce more than half of its income. The VAT is generally deemed more efficient than an income tax because it taxes consumption and encourages saving. Furthermore, VATs are easier to collect, since they are paid by businesses, which are obviously fewer in number than consumers, have a lot more money, and usually keep better records.

Yet despite its advantages, even the VAT is difficult to administer in China. A thriving market in fake invoices has sprung up to circumvent the system. These documents are forged and resold to companies who fill them out with inflated figures that overstate the value of inputs and thereby avoid the tax. This practice continues today despite the execution of people found to have used such phony VAT invoices to embezzle state funds. Chinese businesses also manage to avoid paying VAT by persuading tax authorities that their products are worth less than the raw materials used to make them ‑‑ often the case in inefficient state‑owned enterprises.

UNINTENDED CONSEQUENCES

Placing their faith in technological solutions, Chinese officials are upgrading their computer systems and providing businesses with adding machines to record revenues that can then be checked by the tax authorities' computers. The problem with this process, however, lies in getting people to actually use the new machines.

Making transactions even harder to monitor is the fact that China's remains a cash‑based economy. At least eight of each ten transactions at major department stores in large cities are made in cash. In the countryside, the proportion probably rises to nearly 100 percent. And the incentive to use cash will only grow with the introduction of more technology, as people realize that their transactions are being tracked. Meanwhile, giving people access to better technology may only result in more sophisticated tax evasion.

As in the case of techonological improvements, the structure of some of the newer Chinese taxes may also have unexpected detrimental effects. A tax on interest earned on bank deposits is prompting people to take their money out of banks. But China's four major banks are technically insolvent, and the last thing they need is a diminution of their asset base. A similar problem exists with a proposed social security tax on employees and employers to go into individually owned accounts. Any money set aside in such accounts would be wasted, for where would funds be invested? Chinese government debt? Accounts in insolvent banks? Shares of money‑losing SOES? Speculative real estate? None of these present very attractive alternatives.

The failure of banks to allocate funds to more robust sectors of the economy ‑‑ which, unlike the SOES, show potential for growth and trade in hard currency ‑‑ also limits tax revenue. One of the more energetic parts of the Chinese economy since the mid‑1980s, for example, has been the growing township enterprises that provided the state with 20 percent of its revenues in 1997. Unfortunately, the growth of these famous enterprises, which are theoretically owned by various townships and villages, has been steadily slowing since 1993. Starved by the state banks, their rate of growth has dropped from 65 percent in 1993 to 15.4 percent in 1997. As they continue to lose steam, so will their ability to pay taxes.

The same problem exists with high‑tech, high‑growth manufacturers. For example, Huawei, a telecommunications‑equipment manufacturer, has seen its sales double annually for the last four years. Yet despite its success, the company has had trouble getting a loan. At the same time, notwithstanding efforts by Beijing to get banks to tighten up lending, loans to the inefficient state sector grew by 16 percent in 1998. Tax‑consuming sectors of the economy therefore continue to receive more than ample money, while tax‑producing sectors are starved.

THE NEW MATH

With a budget deficit of only 1.8 percent of GDP and a total domestic debt of only 10 percent of GDP, China's inability to collect taxes may not appear to be an urgent problem. These figures take on a new urgency, however, when considered in light of the government's general failure to raise money. Sixty percent of central government revenues last year came from the issuance of debt. Of that debt, 70.9 percent went to servicing and financing redemption of other debts. China cannot continue to service its debt for long by simply issuing more. It needs the cash that would come with increased tax collections.

Some observers see relief coming from the trade revenues and foreign investment that will be generated by China's entrance into the World Trade Organization (WTO). But euphoria is tempered by foreign misgivings over whether China can faithfully implement the required concessions and handle an influx of foreign competitors. Without the uniformity of law, the likelihood that the regulations of a supranational body will be enforced throughout the country is small, especially if they threaten the SOES, the Communist Party's main power base. Private businesses remain insecure and are unlikely ever to enjoy the inviolable status accorded by China's constitution to state‑owned companies.

In a truly law‑based society, rules deter narrow interest groups from stealing national resources from society as a whole. Without the protection that such rules provide, however, powerful individuals and groups remain free to follow their parasitic path and enrich themselves while impoverishing the country. Such is the case in China today. As long as narrow but powerful interests continue to obstruct the rule of law, the central government will never be able to collect taxes efficiently. And if taxes cannot be collected, China's one‑party government will fall deeper into debt. The economic drought will spread, threatening stability within China, and potentially beyond.╢

William Gamble is a lawyer and a principal in Emerging Market Strategies, a forecast and risk management firm specializing in the global marketplace.