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VAT And China’s Other Taxing Problems

CHINA STARTED TO replace its Business Tax with a value-added tax (VAT) in 2012 when a pilot scheme was launched in Shanghai. VAT has since been steadily expanded, both geographically and sectorally.

Earlier this month, following an executive meeting of the State Council, chaired by Prime Minister Li Keqiang, plans were announced for streamlining the administration of VAT and acknowledging that it has become a universal national tax.

The service sector first saw the tax in May last year when it was applied to property, financial and consumer services sectors. At the same time, VAT was extended fully nationwide.

Authorities say that between then and June, the switch to VAT has saved businesses 85 billion yuan ($12.8 billion) in taxes, providing an important boost to the ‘rebalancing’ of the economy towards consumption. Total tax savings since the pilot scheme started is put at 1.6 trillion yuan.

In July, the four VAT brackets (17%, 13%, 11% and 6%) were reduced to three with the elimination of the 13% bracket. Agricultural products, tap water, publications and several other ‘13%’ goods were moved down to the 11% bracket, though that still leaves more VAT tiers than the international average.

The new plans foresee digitization of the tax system, simplifying procedures for tax filing and switching from physical to electronic versions of the invoices-cum-receipts (fapiao) that serve as legal proof of purchase for goods and services. Fapiao are a key component of enforced compliance with China’s tax law as they compel companies to pay tax in advance on future sales.

The VAT fapiao is also used for tax deduction purposes within VAT, so digitising the whole process should streamline the accounting.

The tax is still referred to as “the VAT reform pilot program” though that status as a pilot looks like ending de jure as well as de facto; the State Council executive meeting also indicated that more detailed national VAT legislation would be forthcoming.

There is more work to be done on standardising it as a national tax. There are still inconsistencies between sectors in the rates applied to the same goods and services. Also, some tax payers are not able to make full VAT deductions. A further issue to address is compliance costs for taxpayers with multiple business locations.

One major issue that a national VAT does not address is how the tax take is shared at the provincial level. (Germany and Japan, for example, use allocation rules based on population and aggregate consumption, respectively.)

However, China has a bigger problem of fiscal redistribution to tackle. The country has the largest share of local government spending in the world, largely because public services and the social safety net (health, education, welfare, etc.) are centrally mandated but delivered and paid for at the local level. Many federal countries decentralise their social insurance system, but China is a rarity in having both its public pension system and unemployment insurance managed at the local level.

Yet, since the fiscal reforms of 1994, provinces and municipalities have negligible revenue raising powers of their own. Further, although 60% of taxes are collected by local government, those taxes are handed over to central government with some to be returned via revenue-sharing and other transfer schemes through rules that are still not completely transparent.

Transfers from the central government were supposed fully to finance local-government deficits since provinces and municipalities were barred from issuing debt.  In practice, however, local governments were given increasingly large unfunded mandates. Because of the prohibition on issuing debt, they resorted to selling land and using off-budget special-purpose vehicles to borrow and spend on infrastructure, starting the infamous local-government debt bomb ticking.

Local governments debt had reached the equivalent of around 40% of GDP by 2015.

A fiscal reform plan was announced in 2016 to address the misalignment, but it will take a comprehensive imposition of taxes such a market-value-based property tax, local surcharges to personal income tax and maybe even an additional provincial-level VAT — though that is difficult technically to administer; few if any countries have pulled it off.

It will also mean converting the pilot scheme for issuing and trading municipal debt started in 2014 when back door borrowing through special-purpose vehicles was banned, into a national muni-bond market. That, in turn, will require broader financial-system reforms.

Those are proceeding at a cautious, measured pace. Short-term stability and state-centric control is the current leadership’s instinctive approach. That may change after the forthcoming Party congress, but, more likely, it will not. In that context, streamlining VAT to puts greater taxation capacity in Beijing’s hands makes political as well as economic sense.

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US Imposes More North Korea Sanctions On Chinese Firms

THE UNITED STATES has given another turn to the financial-sanctions screw it is driving into North Korea. The US Treasury has added six Chinese and Russian individuals and ten organisations with financial ties to Pyongyang’s weapons program to its list of entities banned from conducting business with U.S.-linked companies and individuals.

Most notable among the latest additions is Mingzheng International Trading Ltd, which Washington considers a front company for North Korea’s state-run Foreign Trade Bank, which itself has been subject to American sanctions since 2013. In June, the US Department of Justice filed suit against Mingzheng for laundering money on behalf of blacklisted North Korean entities, seeking to seize $1.9 million of the firm’s funds.

These latest sanctions appear to target coal importers and agencies supplying North Korean labour to foreign countries in its continuing attempt to sever Pyongyang’s supply lines of hard currency needed to fund its nuclear and missile programmes. In the same vein, the US had sanctioned Bank of Dandong, bank, along with Dalian Global Unity Shipping and two Chinese citizens, Sun Wei and Li Hong Ri, in June.

The United States charged that “at least 17%” of the $786m in customer transactions conducted through Bank of Dandong’s  US correspondent accounts from May 2012 to May 2015 involved “companies that have transacted with, or on behalf of, US and UN-sanctioned North Korean entities”.

The bank which is mainly owned by municipal agencies, is small in the order of banks; its assets were only $10.7 billion as of the end of 2016. A bond issuance prospectus last year revealed that the bank a 1% stake in Dandong Xinliu Group, a state-owned company engaged in trade with North Korea.

Unlike the UN sanctions recently announced, which required lengthy negotiations with Beijing, this latest round appears to have been imposed unilaterally by the United States, as evidenced by China’s reaction which was to say the Washington should “immediately correct its mistake”.

For his part, Kim Jong-un has ordered a step-up in the production of warheads and solid-fuel rocket engines for long-range ballistic missiles, taking some of the wind out of the sails of United States officials who have started to suggest that the possibility of a resumption of talks on a negotiated settlement might be appearing on the horizon.

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China’s Press On Academic Freedom

Cambridge University Press, a leading academic publisher whose China Quarterly is one of the leading English-language social science journals devoted to China has reversed its decision to comply with the demands of China’s censors to block sensitive content.

The university press had initially removed some 300 China Quarterly articles on politically sensitive topics from its website in China on the instruction of the media regulator on penalty of not being allowed to publish at all in China.  The press changed its mind following protests, including a petition published by academics from around the world, condemning restrictions on academic freedom of thought.

It was a dilemma that many foreign businesses have faced: the choice between being shut out of the Chinese market for refusing to comply with authorities’ controls of markets or suffer reputational risk outside China by knuckling under. In information markets, the reputational risk of complying with controls on freedom of expression is potentially a higher cost for an academic institution that it would be for a commercial technology or media company. Online content providers,

Chinese and foreign, have been a particular focus of the censors’ attention this year, as online content, previously more laxly regulated than offline media, has been brought under the same control regime as traditional print and broadcast media.

Tech groups and media companies have bowed to government demands to close down hundreds of mobile video platforms and promised to work more closely with state media. Under the new cyber security law that came into force on June 1, only those online content creators who have been issued with a media licence are permitted to upload videos featuring news or political commentary.

This has reinforced Chinese firms’ pre-emptive self-censorship, and more foreign firms to accept specific demands.

Beijing has to tread a careful line with foreign academic publishers. While censoring politically sensitive material is one thing — and social scientists in Chinese universities, once an important source of policy advice to government, have come under greater freedom of expression constraints since President Xi Jinping took over in 2012 — it is another cutting off the country’s scientists and technologists from the latest foreign academic research in those fields.

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China’s ‘Achilles’ Heel’ Of Debt

THE IMF’S LATEST Article 4 consultations report on China’s economy retraces some well-trodden ground. While edging up its projections for China’s growth projections, the Fund again underlines the growing risk from debt in the medium term.

Arguably this is the greatest macroeconomic risk that China faces and which the Fund says needs to be addressed now if sustainable growth is to be sustained. It summarises that risk in a supplementary note to the main report thus:

International experience would suggest that China’s credit growth is on a dangerous trajectory with increasing risks of disruptive adjustment and/or a marked growth slowdown.

Managing the debt issue is inseparable from rebalancing the economy, away from infrastructure investment and export-led growth to domestic consumption.

Progress in rebalancing, the Fund acknowledges, is being made, particularly in reducing industrial overcapacity. Borrowing by local governments is being made more transparent, and regulators have started to address financial sector risks.

The Fund, though, calls, as it has repeatedly done in the past, for the pace of reforms to accelerate, taking advantage of the relatively robust growth the economy is now enjoying.

Its check list of five action points will be familiar:

  • boost consumption by increasing social spending by the government and making the tax system more progressive;
  • increase the role of market forces by reducing implicit subsidies to state owned enterprises and opening up more to the private and foreign sectors;
  • deleverage the private sector by continuing the recent regulatory tightening in the financial sector and greater recognition of bad assets in the financial sector;
  • ensure macroeconomic sustainability by focusing more on the quality of growth and less on quantitative targets; and
  • improve policy frameworks so that the economy can be better managed.

The fund particularly recommends accelerating the reform of state owned enterprises by moving social functions away from them and opening their protected sectors to more private and foreign competition.

There will be a cost to that which will strain the financial system. Bankruptcies will rise with the elimination of blanket state guarantees and lenders that have made uncreditworthy loans will get into trouble. The political concern is that strain on the financial system turns into social stress.

IMF China reforms scorecard August 2017

As this Bystander has noted before, policymakers have been steadily if cautiously managing down the GDP growth rate for several years, mostly by reducing too high investment and too rapid credit growth. They have been less active in opening up replacement sources of growth, notably by opening up to the private sector.

The fund also lays great importance on the need to liberate private savings for consumption by increasing public spending on health, pensions and education, three areas in which its spending is well below the OECD average, and by increasing social transfers to the poor, who are disproportionately greater savers than the poor in other countries,

Again as this Bystander and many others have noted before, the longer China delays tackling the structural underpinning of its debt load, the longer resolving them will take and the greater the risk of not doing so becomes.

This is an opportune moment from an economic point of view to do so. Growth in the first half of the year was more robust than expected with both the global economy and financial conditions being benign. Domestically, the effects of cutting industrial capacity are starting to work through, bolstering profits and areas of the private sector where state-owned enterprises are largely absent, such as e-commerce are showing exemplary dynamism.

Also, balance-of-payments and exchange-rate management have been adept while some old-school fiscal stimulus six to nine months ago has also kicked in.

Markus Rodlauer, deputy director of the IMF’s Asia and Pacific Department, put it this way:

The situation at this point right now…should be used as an opportunity…to bear down and to buckle down and continue with this financial sector adjustment, which is really the Achilles’ heel now of the economy.

Once the 19th Party Congress due to be held in October or November is out of the way, and assuming it has not changed politics appreciably, that may happen more visibly.

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Djibouti Bound

Chinese warships leaving Zhanjiang, Guangdong province, China on July 11, 2017 bound for China’s first overseas military base in Djibouti. Photo credit: Xinhua/Wu Dengfeng.

CHINESE MILITARY PERSONNEL are now en route for Djibouti where they will garrison China’s first overseas military base, which it started building last year at a cost of $590 million.

The photo above shows the departure from Zhanjiang in Guangdong province of the South Sea Fleet’s Jinggang Shan, a Yuzhao class Type 071 amphibious transport dock that had previously been deployed in the search for the missing Malaysia Airlines Flight 370,  along with a second PLA-Navy ship, China’s sole semi-submersible Donghai Island class naval auxiliary ship.

The Horn of Africa country, only half as big again as municipal Beijing, is already home to US, French and Japanese military bases with a Saudi Arabian one, like China’s, under construction.

China’s base will be used for supporting peacekeeping (Beijing has deployed its first UN peacekeeping combat troops in South Sudan), international anti-piracy operations off the Somali coast and in the Gulf of Aden (in which China has taken part since 2008) and humanitarian aid.

It will also provide advanced support, should it be needed, for the more than 250,000 Chinese now working in Africa — and the Chinese investments where they work. Evacuations of nationals have already been needed in Libya and Yemen.

China stresses that Djibouti will be a logistics or support, not military base. The question is, however it is described, whether it is the first of one, several or many such overseas beachheads.

The US defence department’s recent annual report to the US Congress on China’s military prowess took this definitive view:

As China’s global footprint and international interests have gown, its military modernization program and become more focused on supporting missions beyond China’s periphery, including power projection, sea land security, counterpiracy, peacekeeping and humanitarian assistance/disaster relief (HA/DR). In February 2016, China began constitution of a military base in Djibouti that could be complete within the next year. China likely will seek to establish additional military based in countries with which it has long-standing, friendly relationships.

The US defence department pinpoints Pakistan as best fitting that bill. Given the growing economic interests at stake in the China-Pakistan Economic Corridor, which runs through both some insecure but strategically important territory, and China’s extensive role in building a deep-water port at Gwadar on the Arabian Sea coast, that seems a logical deduction.

However, many other countries will not be receptive to the notion of hosting PLA bases, and Chinese military doctrine sees prowess in cyber, space and information warfare as more potent than building a traditional network of military allies.

Indeed, current doctrine sees power projection assets as a vulnerability in modern warfare. That alone will be cause for China to move cautiously on establishing further bases.

At the same time, Beijing will use China’s economic linkages to cement support among those with similar security interests and to deter adversary power projection in third countries, particularly that by the United States.

For now, gaining access to foreign commercial ports for as a logistics base and for pre-positioning of support of “far seas” deployments by the PLA-Navy is likely to be the order of the day. That, anyway, is what would be needed for the HA/DR operations that Beijing is likely to concentrate on while its military learns to find its way around the world.

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China’s Good Muslims And Bad Muslims

IN 2015, AUTHORITIES in Karamay, the oil town in the far north of Xinjiang, China’s troubled far-west province, temporarily banned men with big beards or anyone wearing Islamic clothing such as hijabs, niqabs and burqa from travelling on the city’s buses.

The restriction came a week after an attack in which nearly 100 people, including 59 of the attackers, branded terrorists by authorities, had died, and in the midst of a year-long anti-terrorism crackdown announced in the wake of a deadly bombing attack in the provincial capital, Urumqi, in May earlier that year.

Now, following a futile attempt to discourage beards and veils, Beijing has announced blanket ban across Xinjiang on “abnormal” beards, the wearing of veils in public places and, incongruously, the refusal to watch state television.

The 15 specific measures introduced categorise as ‘extremism’ what could be as easily described as religious observance as proselytising. State media describe them as drawing a clear line between legal religion and illegal religion, providing legal support for protecting the former and purging the latter.

China is far from alone in taking this tack towards its domestic Islamic extremists. France, Belgium the Netherlands, Bulgaria and Egypt are all countries that have imposed varying degrees of prohibitions on face-covering dress. However, as measures to counter religious extremism, China’s latest regulations seem more likely to alienate further the Uighur Muslim population that already feels their culture is under attack from Han Chinese settlers than to reduce the threat levels perceived or actual.

Beijing has been fighting a low-level but increasingly violent insurgency in its natural-resources-rich western reaches for decades. The 8.4 million-strong Uighur minority in Xinjiang, mostly Turkic Sunni Muslims, though far from universally supportive of the tiny separatist groups that would like to re-establish the republic of East Turkestan, resent the growing Han dominance of the province, which was once more four-fifths Uighur but is now dominated by Han Chinese.

Uighurs feels their culture and economic prospects being increasingly diminished, and especially since the anti-Han riots in Urumqi in 2009 that left some 200 dead, initiating the current cycle of crackdowns. That sense of marginalisation has increased since not just by the paramilitary policing that has become part of everyday life but also by the squeezing of the native population out of Party and government jobs, where Islamic observance can be most effectively banned.

In what appears to be a visible defiance of Chinese control, Uighur women have taken to wearing veils, although Uighurs have traditionally not practised strict forms of Sunni Islam that demand them.

However, the same trend is also being seen among women from China’a largest Muslim group, the Hui, who are treated much differently by authorities than Uighurs. Hui are not concentrated in one region but spread out across the country; though of Arab-Persian-central Asian descent they are Chinese-, not Turkic-speaking and are often physically indistinct from Han Chinese. Crucially, they do have any separatist ambitions.

The contrast between the freedom of religious expression for Muslims in central and eastern China and the tight strictures on Uighurs in Xinjiang is striking, and a marker of the difference of treatment for those groups that assimilate and those that do not.

This Bystander has noted before that China’s anti-terrorism policies are based on the same techniques as Beijing uses to crackdown on political dissent, which may betray a fundamental misunderstanding of the problem being faced.

We have also noted the shortcomings of such an approach when it comes to winning hearts and minds. Religious restrictions only serve to feed a vicious cycle of repression and violence. If the aim of counter-terrorism policy is to alleviate the conditions and reduce the underlying factors that give rise to radicalization and recruitment among the domestic population, then characterising all Uighurs as being somewhere on the terrorist/separatist spectrum is not going to achieve that.

Violence has flared up in recent months in Xinjiang’s southern Uighur heartland after a relatively quiet period. Amplified by a fear of the return of battle-hardened fighters from Iraq, Syria and Afghanistan, this has brought a large tightening of security, epitomised by President Xi Jinping’s call for Xinjiang to be surrounded by a “great wall of iron”.

However, while the Party maintains tight controls over foreign religious influences in the country, there is growing physical evidence of more conservative Arab countries such as Saudi Arabia funding the construction of mosques and schools in China, particularly those in the Salafist tradition, which might turn even China’s assimilated Hui Muslims more religiously conservative with unknown consequences.

China has somewhere between 20 million and 40 million Muslims. The official census figures veer towards the lower end of that range, but even that would put China in the top 20 of Islamic countries, though as a proportion of the total population it is tiny, less than 2%.  In future, Beijing may have a different Islamic issue to confront, but for now, it frames the one it has in Xinjiang in the same context as Tibet and Taiwan — and that may render it unsolvable in the only way it knows how, a combination of coercion, bribery and absorption.

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Stimulating Growth Puts Reforms At Risk

THERE IS A sprinkling of optimism, albeit tempered with uncertainty, to the International Monetary Fund’s latest update to its World Economic Outlook. This includes an upward revision to the near-term growth prospects for China on the basis that the policy stimulus that helped deliver 2016’s 6.7% economic expansion will continue.

Strong infrastructure and real estate investment were the stimulative effects. One other consequence noted by the IMF was that deflation has come to an end with capacity cuts and higher commodity prices pushing producer-prices inflation into positive territory after four years.

On the strength of all that the IMF is raising its forecast for 2017’s GDP growth by 0.3 percentage points from its forecast in October to 6.5%.

The balance of risk, as the Fund acknowledges, is to the downside, for both China and the global economy. A shift to protectionism is among the more prominent risks along with a more severe slowdown in China.

That latter event could come if a continued reliance on stimulus measures, with the accompanying rapid expansion of credit, exacerbates the slow progress being made in addressing the issue of impaired corporate debt, especially in light of persistent government support for inefficient state-owned firms — all elevating the risk of the adjustment being disorderly the longer it is left.

Besides, before then, capital outflow pressures could make matters worse, especially given the uncertain external outlook.

The warning about continued reliance on stimulus measures repeats what the IMF said last October:

China’s growth stability owes much to macroeconomic stimulus measures that slow needed adjustments in both its real economy and financial sector.

The foreboding this time could be misplaced.

President Trump might make good his promise of 4% annual GDP growth in the United States and his maxim of ‘buy American, hire American’ turn out to be less protectionist than feared, strengthening demand in US trading partners. Or China could ride history’s tilt towards south-south trade harder, raising demand in its trading partners.

The IMF, for one, is not banking on any of those developments. It has left its forecast for China’s GDP growth in 2018 unchanged at 6.0%.

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