SME Taxation in China

Professor Yang YaoChina 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, RussiaSeptember 14-16, 2003

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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 jurisdictionNew firms shared between central and local equally

Central government monopolizes the special consumption taxAll tax rates are set by the central government and uniform across provinces

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1. China’s Fiscal System

Yingyi Qian: Market-preserving Federalism

Federalism without the side effects of excessive exaction, regional protection and excessive competitionHigh incentive for local governments to expand their tax bases through economic growth

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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 enoughChinese 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 economyRussian federalism does not work because there is not a strong central government

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1. China’s Fiscal SystemIts 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 governmentsResponsibility snowballs down to lower-level governments

Governments become commercialized, acting more like a corporation rather than a public institution

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2.SME TaxationSMEs pay less taxes than large firms

They are more likely to evade taxesLocal 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

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3. Problems with Taxation

High tax ratesValue-added tax: 17%Corporate income tax: 33%Personal income tax: taxable income starts very low and the rate is strongly progressive

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3. Problems with Taxation

Ill-defined tax basesThe VAT is production-based rather than consumption-based, discouraging investment and technological innovationThe 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

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3. Problems with Taxation

Too much discretionary power vested in tax officers

Negotiation of taxes is common Tax burdens are unequalCorruption is inevitable

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4. Government Concessions

FDI enjoys three-year exemption and five-year reduction of income taxExports get rebates on VATHigh-tech products also enjoy certain tax cutsEmploying laid-off workers qualifies tax cuts

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5. SolutionsIncrease check and balance at every level of the governmentLower the tax rates

The effective rate of corporate income tax is already 28%

Make taxation more production-friendlyMake VAT consumption-basedAllow R&D expenditures deducted from corporate income tax

Level the competition field between foreign and domestic firms

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6. Lessons for Russia

Judge local officials by growth rates, not by taxes sent to the central governmentGive SMEs a space

Tax exemptions for initial years of operationTax incentives to obtain specific government goals such as employmentLess strict enforcement of the tax code