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Tuesday, March 28, 2006

Tax Advantages for Foreign Firms in China

Foreign companies locating in China have the advantage of low labor costs. They also pay very low taxes, much lower than domestic Chinese firms, a source of growing political discontent. To solve the problem, taxes on foreign firms located in China must be raised, or taxes on domestic firms must be lowered. The problem is that raising taxes on foreign firms endangers FDI, an important source of growth, and lowering taxes on domestic firms reduces needed tax revenues. Thus, for now, the decision is being postponed:

Beijing's 'separate but unequal' tax dilemma, by Frederick W Stakelbeck Jr, Asian Times: At the ... National People's Congress held in Beijing early this month, NPC spokesman Jiang Enzhu announced that the implementation of the much-anticipated Law on Enterprise Income Tax and the Property Law, designed to unify the income tax rates for domestic entities and foreign-invested enterprises (FIEs), would be postponed. ...

The current Chinese income-tax rate structure has been the subject of intense debate over the past several years. A growing number of Chinese economists, government officials and business leaders have openly criticized the tax policies as being unfair to domestic entities, while at the same time providing competitive advantages to FIEs. ... FIEs pay an average 15% tax rate and Chinese entities pay an average 33%. As a result, FIEs operating in China currently enjoy one of the lowest tax rates in the world.

The generous tax policy has allowed FIEs to reap tremendous annual profits and has facilitated the expansion of their China-based operations. FIEs have flocked to China and taken full advantage of the tax incentives offered by special economic zones (SEZ) and coastal open economic zones (COEZs) to grow their businesses.

In 2001, Beijing pledged to rectify the glaring disparity in the country's income-tax rate structure when it joined the World Trade Organization. The communist government promised to replace the present rate structure with a unified income-tax rate structure that would range from 24-28%. But the proposed changes never materialized, provoking frustration in the Chinese business community and raising fears that preferential income-tax rates would become permanent.

Sources close to the recent NPC summit noted that Beijing's procrastination concerning income-tax reform has been primarily based on fears of catastrophic and permanent foreign direct investment (FDI) losses. Generous FIE tax incentives have fostered foreign investment, which has steadily grown over the past few years... An increasing amount of foreign investment has gone into high-technology sectors such as telecommunications and computers, which are crucial to China's global competitiveness...

Several alternatives have been proposed by various groups to address the country's income-tax-rate dilemma. ... The most likely scenario, and the most controversial, involves Beijing delaying a decision on tax reform indefinitely. Instead, the government would call for additional industry input, cooperative empirical research and independent studies before any broad tax-unification plan commenced...

In 2005, more than 44,000 foreign-funded enterprises were established in mainland China - a tremendous accomplishment by any measure. But few observers would deny that some type of income-tax reform is now needed. ... FIEs [a]re using tax loopholes to evade about $3.75 billion in taxes annually. This, coupled with serious misgivings by the Chinese business community about the fairness of the current dual income-tax system, will eventually force Beijing to take action. ...

If you add up the social services such as health care that the government provides to workers in foreign firms, and also add in government expenditures on roads, police and fire protection, port facilities, legal protection, and so on used by these firms, will 15% minus tax breaks for locating in special economic zones cover the total costs foreign firms impose on China, or is there an implicit subsidy for locating in China built into the tax rates, tax rates that are "one of the lowest tax rates in the world"?

While I can't say for sure, I would guess that an average rate of 15% does not fully cover the costs. At the 24%-28% rate China promised the WTO, tax revenues and costs would be closer to alignment and this would reduce or eliminate the competitive advantage the implicit subsidy provides to foreign firms located in China.

    Posted by on Tuesday, March 28, 2006 at 12:15 AM in China, Economics, International Trade | Permalink  TrackBack (0)  Comments (9)

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