The mainland's decision to impose a maximum tax rate of 25 per cent for foreign and domestic companies alike should be applauded as a welcome reform. But the policy would be even better if it presaged a thorough simplification of a tax code that remains open to abuse.
First, give credit where credit is due. The decision to unify the tax rates for foreign and local companies is a long overdue reform stemming from China's entry into the World Trade Organisation. Although not required by the WTO, the reform is in keeping with the spirit of the WTO, which says that foreign and domestic firms should be treated equally. If passed, as expected, by the National People's Congress next week, the new law will make for a more level playing field by removing a major advantage that foreign firms enjoy and doing away with a policy that has encouraged capital flight.
Most foreign manufacturing firms currently pay a maximum tax rate of 15 per cent, although sweeteners cut the average effective rate still further. Yue Yuen Industrial (Holdings), whose production of Nike and other athletic shoes makes it the world's largest such producer, pays a rate of just 2 per cent. Domestic firms, which now pay a maximum rate of 33 per cent, will save 134 billion yuan annually and foreign firms will pay an extra 41 billion yuan, according to the Finance Ministry.
WTO regulations specify that foreign firms cannot be treated less favourably than domestic ones. The mainland's situation was topsy-turvy, where foreign capital was lured with the prospect of lower tax rates. This created the notorious practice of so-called round-tripping, where capital was smuggled out of the mainland to set up companies in the British Virgin Islands and other secretive tax havens. So many of the 'foreign' firms that will pay higher taxes under the new rules are actually domestic ones that have taken advantage of a distorted system. Getting rid of that distortion is to be applauded. And certainly the mainland, which has been swimming in both foreign and domestic capital, does not need any longer to encourage foreign investment.
The reform comes after a decade of surging tax receipts. As recently as 1995, the central government's tax collections amounted to just 10 per cent of economic output. That has nearly doubled, with central government tax collections now amounting to about 18 per cent of gross domestic product. Thanks to the surging economy, tax revenue jumped almost sixfold from 600 billion yuan to nearly 3.8 trillion yuan in the same period.
But the mainland missed the chance to sweep away a confusing thicket of tax breaks that this reform offered. The revised tax law will include preferential tax rates for a slew of sectors, ranging from bio-tech firms to banks, from shipbuilding to service industries. There will also be favourable tax rates for a wide range of activities such as environmental protection, energy preservation and agricultural infrastructure. Small private firms could see their tax rates capped at 20 per cent. All of these initiatives sound laudable enough.
It is understandable that governments want to use the tax code to shape private-sector behaviour. But these sorts of tax preferences require decisions by officials, usually behind closed doors rather than in public. That is dangerous in any society, because it opens the door to corruption. It is especially true on the mainland, where many government institutions are prey to capture by special interests. The danger is that companies abuse tax loopholes with the help of corrupt tax officials.
The mainland has taken a major step forward with the new reform. But it cannot afford to stand still. It should take a good look at the record of Hong Kong and other simple tax regimes. Russia, which coupled tax simplification with vigorous prosecution of tax cheats when it introduced a flat tax in 2001, has seen growth in part because of its tax reforms.
The overall level of tax collection probably has room to keep rising in order to fund the mainland's pressing social needs, such as education and health care. More simplicity, not more complexity, will aid in this fight.